Investing for Income in Bonds
Making the right Comparisons to Get the most from your Money
Jul 30, 2008
The pure technical definition of “money market” is any debt instrument of one year or less. From a more practical perspective, with a few notable exceptions, it is most always a nine-month maturity or less. The most common maturities are 30 to 90 days. Most people are familiar with money market funds, the following are some examples of what kind of debt instruments go into a money market fund:
• Sovereign debt – Short-term obligations of your country’s treasury
• Government Agency Discount Notes – An obligation of that governmental agency
• Bankers Acceptances – Obligation of a bank (not the holding company)
• Commercial Paper – Obligations of a corporation (carries a credit rating)
• Certificates of Deposit – Obligations of a bank (not the holding company)
• Floating Rate Notes – Although a longer maturity, the interest rate “floats” periodically, pegged to an index.
Short Maturities and Long Maturities
Money market instruments all have “bullet” maturities and interest is paid at maturity. Some sovereign debt, Agency Discount notes, Bankers Acceptances and commercial paper is sold at a discount and mature “par” while Certificates of Deposit are sold at par and pay a coupon interest rate at maturity. Floating Rate Notes are usually intermediate term maturities, are sold at par and pay a periodic variable interest rate.
Intermediate term maturities, for example two to 10 years, are typically referred as “notes” while longer dated maturities are most always called “bonds.” Within that context of notes and bonds, some are “debentures” which is unsecured debt and collateralized debt that is debt secured by an asset, often referred to as “first mortgage bonds. Don’t confuse these with Mortgage-Backed-Securities; these will be the subject of another article.
Comparing Yields on Bonds and Other Debt
When a dealer quotes a “yield,” you would be well served to learn how to compare yields to see what actually ends up in your pocket. It is not as simple as someone might think.
Calculating Interest on a Bond
The first aspect to consider is how the interest is calculated and how often the interest is paid; it is not all the same. Is interest calculated on a 30-day month and 360 day year or is it calculated on a 365 day year and actual number of days? Some simple division can equate the difference; i.e. 5% / 360 X 365 = 5.069%.
Frequency of Interest paid on a Bond
Standard fare for notes and bonds in the US is a semi-annual coupon payment while in the UK it is an annual coupon – once per year. What is that semi-annual payment worth? Whatever the “yield curve” brings on the amount paid for six months. More on yield curves in another article.
The Tax Status of Interest on Bonds
If a portion of the interest you receive is exempt from a certain tax, divide the yield by the reciprocal of that tax rate to arrive at your true yield – that is what stays in your pocket. For example, in the US, one governmental body cannot tax another. Hence, interest on municipal bonds is exempt from federal taxation. Similarly, interest on a Treasury obligation is exempt from state taxation.
For example: 5.00% yield and a 7% tax rate. 5.00/.93 = 5.37%
It is in your best interest to check with your professional tax advisor and/or legal counsel to see what the case is in your particular state, province and country.
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