Question

If you were to invest in a bond, which type of bond would you choose? 500 words

Explain your reasoning, then further discuss the bond market that is associated with your choice, including the particular details in buying and buying, selling, pricing, liquidity, risk, etc.

Answer 1

Part 1 which type of bond would you choose

There are seven main issuer categories:
1.) Treasury bonds;
2.) other U.S. government bonds;
3.) investment-grade corporate bonds (high quality);
4.) high-yield corporate bonds (low quality), also known as junk bonds;
5.) foreign bonds;
6.) mortgage-backed bonds; and
7.)municipal bonds.
Which one do you want? That depends first of all on your tax bracket. If your tax bill is big enough, it will be worth your while to diversify your stock portfolio with municipal bonds, whose yields are lowest, but for a very good reason: The interest payments are exempt from federal income taxes.
If munis aren't for you, your choice of a taxable category depends on your risk tolerance. Broadly speaking, if you want to hold only as much fixed-income as you need to diversify your stock portfolio, stick with Treasuries, governments or investment-grade corporates. There are important differences between the three, but you don't need more than one to be diversified,

Here's what you need to know about each of the seven classes of bonds:
1. Treasury bonds
Treasuries are issued by the federal government to finance its budget deficits. Because they're backed by Uncle Sam's awesome taxing authority, they're considered credit-risk free. The downside: Their yields are always going to be lowest (except for tax-free munis). But in economic downturns they perform better than higher-yielding bonds, and the interest is exempt from state income taxes.
2. Other U.S. government bonds
Also called agency bonds, these bonds are issued by federal agencies, mainly Fannie Mae ( FNM) (the Federal National Mortgage Association) and Ginnie Mae (the Government National Mortgage Association). They're different from the mortgage-backed securities issued by those same agencies, and by Freddie Mac ( FRE) (the Federal Home Loan Mortgage Corp.). Agency yields are higher than Treasury yields because they are not full-faith-and-credit obligations of the U.S. government, but the credit risk is considered minimal. Interest on the bonds is taxable at both the federal and state levels, however.
3. Investment-grade corporate bonds
Investment-grade corporates are issued by companies or financing vehicles with relatively strong balance sheets. They carry ratings of at least triple-B from Standard & Poor's, Moody's Investors Service or both. (The scale is triple-A as the highest, followed by double-A, single-A, then triple-B, and so on.) For investment-grade bonds, the risk of default is considered pretty remote.
Still, their yields are higher than either Treasury or agency bonds, though like most agencies they are fully taxable. In economic downturns, these bonds tend to underperform Treasuries and agencies.
4. High-yield bonds
These bonds are issued by companies or financing vehicles with relatively weak balance sheets. They carry ratings below triple-B. Default is a distinct possibility.
As a result, high-yield bond prices are more closely tied to the health of corporate balance sheets. They track stock prices more closely than investment-grade bond prices. "High-yield doesn't provide the same asset-allocation benefits you get by mixing high-grade bonds and stocks," observes Charles Schwab Chief Investment Officer Steve Ward.
5. Foreign bonds
These securities are something else altogether. Some are dollar-denominated, but the average foreign bond fund has about a third of its assets in foreign-currency-denominated debt, according to Lipper.
With foreign-currency-denominated bonds, the issuer promises to make fixed interest payments -- and to return the principal -- in another currency. The size of those payments when they are converted into dollars depends on exchange rates.
If the dollar strengthens against foreign currencies, foreign interest payments convert into smaller and smaller dollar amounts (if the dollar weakens, the opposite holds true). Exchange rates, more than interest rates, can determine how a foreign bond fund performs.
6. Mortgage-backed bonds
Mortgage-backeds, which have a face value of $25,000 compared to $1,000 or $5,000 for other types of bonds, involve "prepayment risk." Because their value drops when the rate of mortgage prepayments rises, they don't benefit from declining interest rates like most other bonds do.
7. Municipal bonds
Municipal bonds -- often called "munis" are issued by U.S. states and local governments or their agencies, and they come in both the investment-grade and high-yield varieties. The interest is tax-free, but that doesn't mean everyone can benefit from them.
Taxable yields are higher than muni yields to compensate investors for the taxes, so depending on your bracket, you might still come out ahead with taxable bonds.

Part 2 Explain your reasoning, then further discuss the bond market that is associated with your choice

Have you always wondered whether it makes sense for you to buy municipal bonds? The following calculations should help you figure it out.

The basic question is: Is your after-tax return on taxable bonds better than your tax-free return with munis? If you live in a state without an income tax, you've got it easy.
No State Income Tax in Your Equation
First, determine your federal tax bracket; say it's 28%. So you're shaving 28% off your yield on a taxable bond. If the tax-free muni bond yield is less than 28% lower than the yield on a taxable bond (e.g., say it's 27% lower), you're better off with the muni bond.
Here's an example: Let's say a 30-year Treasury bond is yielding 4.62%, and the yield on a 30-year insured muni bond is 4.21%.
Forget reaching 28% -- the muni yield is only 8.9% lower than the Treasury yield, making the muni the obvious choice. Looked at another way, your after-tax yield on the Treasury (28% lower) would be just 3.33%. To beat the muni, you'd need a taxable yield of at least 5.85% (4.21%/(100%-28%)).
The federal income tax calculation alone usually determines whether a given investor should buy municipal or taxable bonds, even if the investor is choosing between munis and investment-grade corporate bonds, which yield more than Treasuries. (Note: More and more muni bonds come with insurance, which guarantees on-time interest and principal payments and provides a triple-A rating.)
Going back to 1986 -- the last time tax reform caused a major repricing of municipal bonds relative to taxables -- the yields on A-rated municipal bonds have been 20% to 30% lower than the yields on A-rated corporates; they have averaged 26% lower. This means that if you were in at least the 28% Federal tax bracket, you still would have done better on average with munis than with corporates.
If You Pay State Income Tax
If you live in a state with income tax, the process of choosing between municipal and taxable bonds is a little more complicated. In general, you don't pay state tax on munis issued in your state, and Treasuries are not taxed at the state level.
The chief benefit of buying munis outside of your state is diversification. A national muni bond fund is going to be more diverse than a single-state fund. But if you're in a big state, you probably don't need to look beyond your borders in order to diversify.
There are four main comparisons you might make:
1. State-Issued Municipal Bonds vs. Treasury Bonds
The simple calculation described above is all you need to do. Because neither investment generates income that's taxable at the state level, it's as if you lived in a state without an income tax.
2. Outside-State Issued Municipal Bonds vs. Treasury Bonds
The muni yield is taxable at the state level, the Treasury yield isn't. So to do an apples-to-apples comparison, you need to adjust the muni yield for state taxes and the Treasury yield for federal taxes.
If you don't deduct your state tax payment from your federal tax bill, you can simply lower the Treasury yield by your federal tax rate and the muni yield by the state tax rate.
If you do deduct, lower the muni yield by your effective state tax rate, which is your state tax rate adjusted downward by your federal rate. Example: Your federal rate is 28% and your state rate is 6%. Your effective state tax rate is 6% lowered by 28%, or 6% - (0.28 x 6%) = 6% - 1.68% = 4.32%. So you'd lower the Treasury yield by 28% and the muni yield by 4.32%, then compare the two.
3. State-Issued Municipal Bonds vs. Corporate Bonds (or Agency Bonds)
The munis are totally tax-free, the other bonds are taxable at all levels. You need to adjust the taxable yield for all taxes. If you don't deduct your state taxes from your federal taxes, then lower the taxable yield by the sum of your federal and state rates. If you do deduct, lower it by the sum of your federal and effective state rates.
If you're comparing munis to a U.S. government bond fund, which contains both Treasury and agency bonds, only a portion of your earnings will be subject to state income tax.
Unless a fund observes limits on how much of its assets it will invest in non-Treasury bonds, you can't know for sure how it's going to affect your tax bill, but the fund company should be able to tell you how the manager has allocated the fund's assets historically.
Apply this calculation to the portion of the fund's dividend you expect to be state taxable, adjusting the rest for federal taxes only. Say, for example, a fund historically has paid out income 25% of which is tax-free at the state level and 75% of which is fully taxable.
With a federal rate of 28% and a combined federal and state rate of 4.32%, you'd need to lower the fund's yield by 31.2% to do a fair comparison with munis issued in your state.
Here's the math:
(0.28 x 0.25) + ((0.28 +0.043) x 0.75) =
0.07 + (0.323 x 0.75) =
0.07 + 0.24225 =
0.31225 = 31.2%
4. Outside-State Issued Municipal Bonds vs. Corporate Bonds (or Agency Bonds)
The munis are taxable at the state level, the others are taxable at all levels. If you don't deduct, lower the muni yield by your state rate and the taxable yield by the sum of your federal and state rates. If you do deduct, lower the muni yield by your effective state rate and the taxable yield by the sum of your federal and effective state rates.
If, as above, you're looking at a U.S. government bond fund, apply this calculation to the portion of its income you expect to be state taxable, adjusting the rest for federal taxes only.