Taxes Are Critical
Your tax bracket determines whether tax-free municipal or taxable bonds are better. To find the taxable-equivalent yield of a muni, divide its yield by 1 minus your federal tax rate. If you’re in, say, the 35% bracket and a municipal bond pays 3%, its TEY is 4.6%. So buy the muni unless you can get at least 4.6% from a similar taxable bond. Figuring TEY is trickier when state taxes come into play. A Morgan Stanley tool will do the work for you.
New Bonds Versus Oldies
Brokerages sell new and previously issued bonds of all types. For a new offering you generally pay face value, and the sales charges are baked into the interest rate. Commissions are normally higher on older bonds. To build a complete bond portfolio, though, you’ll need to choose among issues trading in the secondary market to stagger interest-payment dates and maturities. Don’t pay more than 100 cents per dollar of principal if the bond may be called, or redeemed, anytime soon for face value.
Focus on Yield
Bonds are listed with several yields. The most useful figure is yield to maturity, or YTM. That’s what you’ll earn from the bond over its life, including interest payments and changes in principal value should you buy the bond at a price other than par, or face value. You can compare YTM of any bonds, whether taxable or tax-free, high-quality or junk. Current yield, a bond’s actual interest rate divided by its current price, isn’t as accurate as YTM if you plan to keep a bond permanently for its income stream.
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Get Checks Regularly
Most bonds pay interest twice a year, six months apart. Buy 12 different bonds—a fair minimum for a diversified portfolio—and look forward to 24 paychecks a year. Sweet! Get a blank spreadsheet and start with January, February and so on. Then find appropriate bonds from sources such as Fidelity and Schwab and fill in your calendar.
Think Safety
Rating agencies no longer carry as much clout as they used to. Still, in a recession a bond rated double-A is likely to hold its value better than one with a rating of double-B or lower (junk-bond territory). More important than the rating are the purpose and backer of an individual bond. With municipals, the surest bets are essential-service revenue bonds, which pay you from school taxes, bridge tolls, or water and sewer fees rather than from general state or local budgets. With corporate bonds, look for companies with relatively little debt compared with equity.
When You Should Sell
When most people buy bonds, they plan to hold to maturity. Exceptions? One is if the issuer is in clear financial trouble or becomes embroiled in a scandal. Another sell signal would be if inflation, the big enemy of bond investors, were to spiral up. Given today’s economic weakness, that isn’t likely to be a problem soon. Finally, if interest rates continue to fall, consider pocketing your gains (bond prices and interest rates move in opposite directions) and looking for better income ideas.