What Are Tax-Free Bonds?
Tax-free bonds, just by their name, sound like a great investment option for those looking to spend their money smartly and wisely. It seems like something which may be too good to be true, but to see if they are worth your time, we must first define what exactly they are. Tax-free bonds are bonds that are issued by enterprises within the government. These bonds will have a fixed interest rate, and all money that they make from them are then used in various infrastructure projects as an investment. These bonds also have a long-term maturity, typically at the rate of 10, 15, or 20 years.
Why Use Tax-Free Bonds?
Recently, tax-free bonds have surged in the financial investment field, as more and more people see the benefits they see how their taxes benefit from this kind of investment. One of the strongest and most important of these advantages it that all of the interest made on these bonds is tax-free. It is exempt from having to be taxed by the government. As such, however, there will be no tax deduction available for the amount that you have invested. However, the ability to have tax-free income is a benefit which cannot be understated.
Who are the Best Candidates for Tax-Free Bond Investments?
Like any investment, tax-free bonds will be better suited to individual investors than others. Not every investor is going to have the background, the capital, and the abilities that are necessary to make tax-free bonds an investment that is worth the time and resources. They are best suited for those who already have a steady and reliable source of income, as they will need it to be able to pay for the long-term lock-in of the capital.
What about the Interest Rates?
One of the most important things to consider with tax-free bonds is the interest rates that are attached to them. The interest rates in connection with the tax-exempt bonds are always going to be linked to major and most prevalent interest rates of government securities. As such, tax-free bonds and their interest rates become even more popular and advantageous when the interest rates in the governmental financial system are at the higher end. You will see a stronger investment in periods such as this. This is also one of the most popular reasons for people to invest in tax-free bonds.
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Credit Risk with Tax-Free Bonds
For those who are looking to see whether or not there is going to be a large risk involved in the investment , there is little to worry about. The basic principle of the tax-free bond ensures that there is little credit risk. All bonds are given out by government-backed companies, and because of this there is a very small risk of the repayment being missed or ignored. There is little to no credit risk involved when investing with tax-free bonds. This is another large advantage to using tax-free bonds over other forms of investment.
Liquidity of Tax-Free Bonds
Yet another factor that should be considered with tax-free bonds is how liquid it will be. For those looking to liquidate their assets, and make money fast, this is an important factor. This is one area where tax-free bonds work well with only particular forms of investor philosophies. Many of these tax-free bonds get traded on various stock exchanges. Often they will be used as an exit for other investors. However, because these investments are meant to be a long-term investment, they do not offer a high liquidity rate that other forms of investment may receive.
Secondary Markets and Tax-Free Bonds
For those who are looking to make a large investment, one of the first things that they want to know about is whether they can retrade this investment into another market. It makes sense, as many people find a fast trading and investment strategy to be highly beneficial for them. With the tax-free bonds, they can be traded onto various stock exchanges and into other markers. While any and all interest which the owner makes off of these bonds remains tax-free, the money that is made from the sale of these bonds is not tax-free. Taxes must be paid on any money which is made from selling a tax-free bond.
As we wrap up, it is important to learn that the type of investment that you choose will vary largely on what your end goals are. In order to choose the right investment, and to make a smart decision on how you invest your money, you will need to have a clear idea of what your goals are. For those who are looking for a long-term investment, the benefits that have been outlined for tax-free bonds are difficult to ignore. However, for those who want a shorter-term investment, they may want to look elsewhere.
U.S. Bonds’ “Elephant In The Room”
Posted on | Options Trading Strategies
There are many “short hand” methods of gauging the market view of average investors at any given moment. One of the simplest of these “short hand” analytical tools is to review yearly and monthly “Funds Flows” within ETFs. According to data from Bloomberg, flows into equity ETFs during 2014 were quite strong, which is hardly surprising given equities’ positive performance during the year.
What might seem surprising, however, is that eight of the top spots within 2014’s list of “Top Ten ETF Inflows” were equity-based ETFs. By way of comparison, in former years there was a broader mix of top asset gatherers.
This dominance by equity ETFs during 2014 does not mean that fixed income ETFs were neglected. In fact, funds flows into fixed income ETFs during 2014 were so strong that they set a new record for the bond ETF space!
However, investing in bonds during 2014 was not for the faint of heart. During late January’s bigETF.com Conference that drew almost 2,000 financial industry professionals and investors toHollywood, Florida, one of the most vocal and heartfelt topics of conversation (including some handwringing) was a “Monday Morning Analysis” regarding why the bond market acted as it did during 2014. The fact is that the key dynamic that most impacted U.S. bonds in 2014 was what I refer to as the “Head Scratching Syndrome”!!
Here is why I describe the 2014 bond space in that way:
1) For the past three to four years, most of the financial advisors from whom I heard have warned of the danger lurking in bonds because (some variation upon the following:) “Historically low interest rates are extremely vulnerable to a rise in rates, which inevitably leads to lower bond prices.” During each of those years, such advisors looked like the “Boy Who Cried Wolf”.
2) Especially as we approached the beginning of 2014 (following the 2013 mid-year swoon in equity and bond prices following Ben Bernanke’s “Taper Tantrum”… Wall Street Analysts were fairly unanimous that higher U.S rates (and lower prices) were imminent. Hence, they warned all buyers of bonds that they should “Beware!”
3) What was the “Result?”
a) At the end of 2013/beginning of 2014, U.S. 10-year Treasury Notes yielded close to3 percent.
b) By the end of 2014, the 10-year had fallen to a 1.8% yield!
c) As a result, the hate mail and vitriolic voice messages left for financial advisors escalated considerably during 2014!
d) A growing lack of faith in the efficacy of investment counsel from Wall Street has prompted a growing number of investors to seek out “new” sources of guidance regarding investment ideas and asset allocation… including the proliferation of “Robo Advisors” who offer model asset allocation portfolios which include “built in” automated rebalancing and tax loss harvesting!! 
At that Hollywood, Florida conference, the Chief Investment Officer at ETF.com, David Nadig, offered this observation: “There’s a lack of understanding about what the hell happened last year.”
Building on this theme of Wall Street “confusion”, Jeffrey Gundlach pointed this out: “Last year was one of the best years ever for 30-year bonds. Now, a lot of investors are afraid not to own Treasuries because they performed so well.” Of course, there are twin dangers contained within the truth of that observation:
1) Longer-term bonds are the ones that carry the highest interest rate risk;
2) One should never assume that “past results are in any way indicative of future performance.”
It appears that 2015 will be no easier an environment within which to invest! Just take a look at the performance of the iShares 20+ Year Treasury Bond (TLT) during January… as the U.S. exhibited positive growth in production and earnings while most of the rest of the world was struggling with sluggish growth … including widespread fear of deflation! Combine that with ongoing strength within the U.S. Dollar and a combination of weakness and volatility within U.S. equity markets and (as you see below) TLT looked like a prime thoroughbred horse rounding the curve at the Derby, anxious to win the race! (its candlesticks took a path straight upward!).
That was the backdrop within which investors pulled almost $16 billion from U.S. Equity ETFs during January (2015) while (seemingly) piling into bonds. In fact, if investor interest in bonds between this month (February) and this coming December averages out to be approximately the same per month as was invested bonds during January, then 2015 will see $41 billion morefunds flowing into bonds than that asset class attracted during all of 2014!!
But as February started, there was just one problem — severe skittishness among investors because the bond market has not been acting “normally” for a long, long time! All it took to put the skids on bond enthusiasm was the February 6th labor report from the notoriously unreliable U.S. Bureau of Labor Statistics … combined with more news regarding how the new Greek government was handling (or not) the servicing of that country’s debt load. Here is what TLT has done so far in February (through February 9th):
Consider these ironies:
1) Yes, the Nonfarm Payroll numbers for January were a big surprise on the upside! However, this data from the BLS comes from the very same folks who somehow misplaced147,000 workers in November and December (the number of workers added through prior month revisions to the November and December NFP reports!);
2) Since the Financial Crisis began, the U.S. Markets have (upon several occasions) been held hostage (so to speak) by news regarding how Eurozone leaders (and more significantly, Euro banks) were handling Greece’s struggles in servicing their outsized debt.
With all this attention focused upon Greece, one might think that its debt (relative to Euro debt as a whole) was astronomical. But consider this – what U.S. economic region could be considered equivalent to Greece relative to its GDP? California, perhaps? Not even close. Illinois? No! Connecticut? Absolutely not!
Instead, the apt parallel with regard to Greek GDP is the Dallas/Fort Worth area of Texas! Keep that in mind the next time you see that news from Greece is shaking up the investment markets in the U.S.
Showing how jittery the market was on the day of the January Nonfarm Payroll Report, take a look at this graph of iShares Barclays 1-3 Year Credit Bond Fund (CSJ). As its name implies, CSJ sits well toward the conservative side of fixed income risk, and yet the candle on February 6th gapped down at the open and never significantly recovered. The measured move on that day was over 15% greater than normal… which is high for short-term bonds.
Reflecting this skittishness, is the fact that on a 2015 year-to-date basis, five of the top ten highest ETF fund flows have been into bond funds – with the leader being one fund even more conservative than CSJ. That leading ETF was the iShares Short Treasury Bond ETF (SHV). During this period, $2.5 billion was drawn into SHV — with $2 billion of those funds arriving on a single day!
Getting to the Point:
What has caused this enigmatic behavior within the fixed income universe? The following graph can not account for all of the factors that have made fixed income investing much more complicated these days… but it absolutely illustrates the single most significant factor which has “rocked” the fixed income world (and the investing universe in general):
Consider these graphs that breakdown ownership of U.S. Treasury Securities as of the Third Quarter of 2012:
The U.S. Federal Reserve then held 14.6% of U.S. Treasury Debt. A significant amount to be sure. However, between then and 2014, the FED increased its holdings by (an amazing) 47%!! Performing the precise math with regard to the percent the FED held by 2014 is beyond the scope of my analysis here… but a “back of the envelope” calculation puts its percentage owned by 2014 atalmost 21.5%!!
Through the years, we have all heard the repeated refrain that our mounting U.S. Federal Debthas made us “beholden” to major foreign holders of our debt – primarily Japan and China (see graph below). There is no denying that entities across the globe have been heavily invested in our bonds. However, given that aggregate foreign holders accounted for over 48% of U.S. debt in 2012… and China held 21% of those foreign holdings (ie. 10% of U.S. Debt in 2012), while Japan held 20% (ie. 9.6%) … the FED now dwarfs both countries vis-à-vis U.S. Debt.
It can be said that the FED became the “Elephant in the Room” regarding the trading/pricing of U.S. Treasury Debt!
Some of you might think – “Hey, that’s OK. After all, it is natural for the U.S. central bank to hold U.S. Treasury Debt!!”
But this is the key point: What is entirely “Unnatural” about the above is that the FED bulked up its Balance Sheet by a factor of four between 2007 and 2014 in order to purchase most of that debt! The FED accomplished this through its several “Quantitative Easing” programs (QE I, QE II, QE III).
So I ask you:
1) Given these dislocations and artificial mega doses of sovereign-sourced liquidity “sloshing” around within global economies and marketplaces; and
2) Given that those forces have conspired to make the normally more predictable, more reliable bond market both less reward (rate wise) and more risky (volatility wise).
Where can investors find a “haven” for their investable funds?
Alas, that has become the perplexing, “$64 Million Question” within the global investing universe? Since the world we live in carries U.S. interest rates that are much lower than anyone could have predicted as recently as 2-3 years ago … a world in which West Texas Intermediate Crude Oil sank lower than most would have guessed as recently as 2-3 years ago… a world within which the U.S. Dollar has risen further (and Gold priced in dollars has fallen further) than anyone would have imagined 3-4 years ago… precisely where should we invest our own personal capital?
Confirming the dilemma we face — a number of major investment concerns have warned that we are in a much more challenging investment environment than we have been since 2010! For example, the chief economist at Vanguard Group (Joe Davis) [Vanguard is a mega-giant mutual fund and ETF vendor] recently offered this warning: “[we have] the most guarded outlook for markets since 2006. It’s going to be challenging going forward.”
Specifically, Vanguard projects that a “generic basket of stocks and bonds” will return less than 6% during the course of the next five years! That is done from the average return since 1926 (8.7%) and the return generated in 2014 (7.3%).
In days (long) gone by, one could invest in U.S. Treasury Bonds and as long as those bonds were held over a 3-7 year period, the average return received was relatively stable and dependable. In 2014, rates were so low that investors were pushed to stretch their normal, comfortable “risk tolerance” profile in order to garner reasonable returns. The unfortunate result was that many investors became unsuspecting victims of volatility levels higher than projected … and therefore returns that can hardly be categorized as either “stable” or “dependable”.
In our next article, we will explore some logical reasons for fixed income volatility… moving beyondjust the U.S. Federal Reserve’s several “QE” programs to explore the implications of bond guruBill Gross having been so utterly wrong regarding his 2011 prediction (and warning) regardingU.S. Treasury Securities … as well as how a bold (but arcane) fixed income trade made in London by Bruno Iksil rattled the markets, made Jamie Dimon suffer through innumerable headaches and sleepless nights, and will be remembered (forever) as ignominious within the annals of “trades gone bad”!
Following that purview, we will offer some real life options that investors can consider if they are interested in reviewing fixed income returns vis-à-vis various levels of risk.
The author currently holds an iron condor position within TLT… as well as a wide range of fixed income funds and ETFs that have not been mentioned in the text above. Nothing in this article is intended as a recommendation to buy or sell anything. Always consult with your financial advisor regarding changes in your portfolio – either subtractions or additions.
 “Funds Flows” is simply the measurement of investor funds into and out of each ETF. Over the course of a month, a quarter, or a year, a review of “NET” flows (inflows minus outflows) can serve as a barometer of market sentiment regarding equities vs. fixed income, U.S. equities vs. global equities, US Treasury bonds vs. corporate bonds, etc. Flows can also suggest market opinion regarding particular sectors within the equity space.
 Recall that international financial giant USB issued a blanket warning to their clients who held or purchased bonds that interest rate risk had heightened considerably (the investment world equivalent to the Surgeon General’s warning on cigarette packs).
 At least them, if the investment decisions are wrong, you can “kick” the computer or an algorithm!
 Gundlach has grown in stature to become almost a “twin” of Bill Gross in terms of the frequency with which his quotes about bonds appear in the financial press. He runs DoubleLine Capital LP.
 A debt accumulated over a number of years as the result of what many German leaders and a high number of financial experts consider to have been profligate governmental spending.
 Yes, I know that Greece is currently serving as a “totem” for all of the debt issues tied to thePIIGS (Portugal, Spain, Italy, Ireland, Greece, and Spain). So although Greece is the “smallest” component of that mix… what the EuroZone does to resolve Greece’s debt will set a precedent, for good or ill, for the rest. Let it be noted, as well, that Ireland has made great progress in bringing its debt load into manageable condition.
 NOTE: I did not use the adjective “safe” before haven!
 The second largest asset manager, following BlackRock Capital (number one).
5 Main Types of Financial Bonds
If you plan to invest in bonds, you have a lot of options. Here’s a list of the main categories of bonds.
Table of Contents:
• Treasury Bonds
• Agency Bonds
• Municipal Bonds
• Corporate Bonds
• Mortgage Bonds
In case you don’t know what a bond is, here’s a quick definition: a bond is an IOU. It means someone is indebted to you and must pay you back the loan with interest.
Now let’s look at the 5 main types of bonds:
1. Treasury Bonds
The United States Department of the Treasury issues treasury bonds. These are widely considered to be the safest bonds to purchase. The U.S. government is one of the richest and most stable governments on the planet.
The Treasury also issues treasury bills and treasury notes. Here’s the difference:
• Treasury bills (T-bills) have a maturity date of fewer than 2 years.
• Treasury notes (T-notes) have a maturity date between 2 and 10 years.
• Treasury bonds (T-bonds) have a maturity date over 10 years.
Interest on treasury bonds is exempt from Federal taxes. Local and state taxes may still apply.
2. Agency Bonds
Agency bonds come from quasi-government institutions. These groups raise money with the intention of helping the economy.
The three biggest examples are:
• The Federal National Mortgage Association (Fannie Mae)
• The Government National Mortgage Association (Ginnie Mae)
• The Federal Home Loan Mortgage Corporation (Freddie Mac)
The U.S. Federal government is not obligated to financially back these agencies. However, some investors speculate the government would help them if they needed it.
These agencies have minimal credit risk. Many consider these relatively safe bonds to purchase.
Agency bonds usually pay higher interest rates since they are slightly riskier than treasury bonds.
They are usually taxed at federal and state levels.
3. Municipal Bonds
Municipal bonds (munis) come from local governments. They are categorized into investment-grade or high-yield classes.
Investment-grade means the local government is less likely to default, but they typically pay lower interest.
High-yield means the local government is more likely to default on its loans, but they pay higher interest.
Local governments do default on their loans from time to time. A modern example is Detroit.
Municipals bonds are exempt from taxes. That doesn’t mean they produce more money though. Other bonds may be taxed, but they can still give higher yields.
4. Corporate Bonds
Corporate bonds fall into two categories:
• Investment-grade corporate bonds (high quality)
• High-yield corporate bonds (low quality). High-yield bonds are sometimes called ‘Junk bonds.’
Investment-grade corporate bonds mean the company is less likely to default on its loans. They typically offer lower interest rates.
High-yield corporate bonds mean the company is more likely to default on its loans. Therefore they offer higher interest rates.
Standard and Poor’s ranks companies on their risk of defaulting. The top of the scale begins at AAA, then descends to AA, A, BBB, BB, B… and so on.
If a company ranks BBB or higher, then it has investment-grade bonds. If a company ranks lower than BBB, then it has high-yield bonds.
Corporate bonds are taxed.
5. Mortgage Bonds
Mortgage bonds finance real estate assets such as houses. Fannie Mae, Ginnie Mae, and Freddie Mac issue most of these bonds. Investment banks can also issue them.
When a bank issues a mortgage, it rarely keeps ownership of the mortgage. The bank will sell the mortgage to a government agency or investment bank.
These institutions take on a lot of mortgages. In turn, they issue bonds using the real estate as backing.
They’re essentially passing a loan onto investors.
Once a bank or agency receives mortgage payments, they will pass on the money to bondholders in the form of interest.
If homeowners default, their property and equipment can be liquidated to repay bondholders. Typically, homeowners pay off their mortgage, since they want to keep their homes.
A glaring exception to this rule is the 2008 housing market crash. Consequently, some investors buy these bonds with caution. Today, institutions have regained a lot of trust from investors.
If homeowners default on their mortgages, their property is collateral for bondholders.
These bonds are taxed at all levels.
Which bonds will you invest in?
Financial Bonds Made Simple
If you need a crash course on financial bonds, you’re in the right place.
In this post I’ll explain:
- What a bond is
- The components of a bond
- How bonds are issued
- How to buy bonds
Let’s jump in.
What is a Bond?
A bond is an IOU. It’s a paper that says, ‘So-and-so owes you money.’ So-and-so is usually a company or a government.
Whoever owns the bond is called a bondholder. Whoever issued the bond is called the bond issuer.
The bond issuer took out a loan. Now he must pay off that loan with interest. He makes payments to the bondholder.
A bond is a security that guarantees the debt will be paid. The company or government must honor the bond by paying money to the bondholder.
For example, if you own a treasury bond, it means you’re lending money to the U.S. Department of the Treasury.
Now the Treasury must make interest payments to you until the debt is paid off. The bond designates a time when the Treasury must fully pay its debt.
What are the Components of a Bond?
There are many different kinds of bonds. Some include more sections than others.
But almost all bonds have 6 essential parts:
1. The Principal
The principal is the amount of money on the bond. It’s the amount originally loaned. It’s also the amount that must be paid back.
A common principal amount for Treasury bonds is $10,000.
2. The Coupon (Interest Rate)
The coupon is the interest rate. It’s based on the principal amount. In our example, the principal for the Treasury bond is $10,000. Let’s say the interest rate is 4%.
The interest payment comes out to $400. In the case of Treasury bonds, they pay interest every 6 months. That comes to $800 dollars a year.
3. The Maturity Date
The maturity date is when the bond issuer pays back all the money. It’s the ‘due date’ for the loan.
Some bonds have a maturity date as early as one year. Others have a maturity date as late as 35 years.
4. The Yield
The yield is how much money the bond is producing in a year. In our example, our Treasury bond is giving us $800 a year.
5. The Market Price
You can buy and sell bonds. A lot of factors affect the price of a bond:
Who’s the bond issuer?
How much does the bond yield?
What’s the bond’s maturity date?
What are the prices of other bonds?
These variables affect the price of a bond on the market.
6. Credit Quality
There’s a chance that the bond issuer can’t pay the money back. That’s where credit quality comes in.
Credit quality analyzes a bond and says, ‘Yeah, the bond will be paid at the end’ or it says ‘No way this bond will be paid off at the end.’
Worried a bond issuer can’t pay what they owe? Check out the bond’s credit quality.
How are Bonds Issued?
There are a few ways a company or government can issue bonds.
In the case of government bonds, they are issued by an auction. The public, banks, and organizations can attend the auction and bid on bonds.
In the case of business bonds, they usually need the service of an external organization. They can go to a public authority, the government, an institution, or another company.
Typically a bond issuer will use the help of banks and security firms.
The organization will buy all of the bonds from the bond issuer. Then the organization will resell the bonds on the market.
After that, the bonds are in the hands of people like you and me.
How do I Buy Bonds?
There are a few ways to acquire bonds. Here are three options:
The U.S. Treasury Department – The Treasury has a website called TreasuryDirect. You can learn how to buy bonds there.
A Brokerage – There are online brokerages who sell bonds. You can view a list of brokerages here.
An Exchange-Traded Fund (ETF) – There are many kinds of ETFs, and one option is a bond ETF. This is a portfolio of bonds that are traded on the market. ETFs are usually managed by a broker.
There’s still a lot to learn about bonds, but that gives you a solid introduction to the subject.
Are you considering buying bonds? Do you have more questions about bonds? Leave a comment and let us know!
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