About Bonds

Bonds are securities issued by a borrower to raise money. In exchange, the issuer pays interest at an agreed rate over time and repays the principal at maturity. Depending on the issuer, bonds can generally be divided into government bonds, financial bonds, and corporate bonds. When investors buy bonds, they are essentially lending money to the government, large companies, or other issuing institutions. Among these three, government bonds usually carry the lowest risk because they are backed by government tax revenue, but they also tend to offer the lowest returns. Corporate bonds carry the highest risk, but they may also offer the highest potential returns.

Lower-risk bonds are generally government bonds. Government bonds can be divided into marketable and non-marketable securities. Marketable securities are highly liquid and actively traded in the secondary market, while non-marketable securities cannot be traded in the market once purchased.

  • Four types of marketable securities: Treasury Bills (T-Bills), Treasury Notes (T-Notes), Treasury Bonds (T-Bonds), and Treasury Inflation-Protected Securities (TIPS)
  • Non-marketable securities: such as State and Local Government Series (SLGS), Government Account Series debt issued to government-managed trust funds, and Savings Bonds

Some bonds have a fixed coupon rate. For example, 5% means you can receive 5% interest annually. Some special bonds use special rules, such as I Bonds being tied to inflation, EE Bonds doubling in value after 20 years, and zero-coupon bonds being sold at a discount.

Here is a general overview of bonds:

  • Yield: 0.1%-9%
  • Risk: Low for government bonds; other bonds depend on the issuer
  • Flexibility: Low
  • Return schedule: Semiannual / annual / at maturity
  • Fees: None
  • Taxes: Interest tax / capital gains tax

How to Buy

For bonds issued by the U.S. government (U.S. Treasury Securities or U.S. Treasuries), you can buy them directly from the official website:

For other bonds, you can buy them through some of the third-party investment platforms mentioned earlier; the platform I use here is Schwab. Unlike CDs and savings products, bonds are often available only during specific issuance windows, so if you want newly issued bonds, it is best to watch the timing. Of course, you can also buy bonds in the secondary market. You can also buy bond ETFs through stock investment platforms, which removes the timing restriction.

I Bond

Because inflation has been severe recently, the yield on US Treasury Series I Savings Bonds (I Bonds) became unusually high among bond options. Bonds issued from May 2022 through October 2022 carried a rate as high as 9.62%!

The main reason is that this bond is tied to inflation, and its rate is recalculated every six months. The formula below shows that the rate is closely related to recent inflation. And since the current fixed rate is 0, inflation is the main driver.

Composite rate = [fixed rate + (2 x semiannual inflation rate) + (fixed rate x semiannual inflation rate) ]

A few things to keep in mind:

  • Eligibility: The buyer must have an SSN and fall into one of three categories: U.S. citizen, U.S. resident, or U.S. government employee. My understanding is that if you file taxes as an RA, then you can buy them. If you have children, you can also buy one for each child.
  • Limit: Each SSN can buy up to $10,000 in electronic bonds per year (purchased directly on the website) + $5,000 in paper bonds (available only through a tax refund by filing Form 8888; these can later be converted into electronic bonds)
  • Redemption: This is a non-marketable bond and cannot be traded in the secondary market. It has a 30-year term and must be held for at least 1 year before redemption. If you redeem it before holding for 5 years, you forfeit three months of interest.
  • Taxes: No tax is due if you do not redeem it. After redemption, you only owe federal tax; it is exempt from state tax.

So at least from this perspective, even if you hold it for just one year and then sell, that 9% rate still easily beats other bonds. If you have extra cash to invest, I would prioritize maxing out the $10,000 annual I Bond purchase.

EE Bond

Series EE Savings Bonds (EE Bonds) are another interesting government bond. The stated interest rate is only a tiny 0.1%, but the government guarantees that if you hold the bond for 20 years, its value will double. That works out to an effective annual return of about 3.5%. However, if you cash out early, you do not get that doubling benefit. If you want to set aside a stable pool of money for a child or for retirement, this bond can also be a decent option.

Yields on Other Bonds

The yields on most other bonds are fairly standard and are similar to CDs. This is bond information I found in Schwab in August 2022. You can see that bond yields were a bit higher than CDs in the short term, while over the long term they were about the same. Under the conditions at that time, the difference between buying bonds and CDs was not very large. If you want stability, buying government bonds directly is probably enough.

Risk

Bonds are not protected by the FDIC, so they do carry some risk. The risk depends on whether the company issuing the bond could fail, or whether a country could default. For U.S. Treasury bonds issued by the U.S. government, the theory is that there is very little risk as long as the United States itself does not collapse. For corporate bonds, I would suggest sticking to AAA-rated issues only in order to reduce risk as much as possible.

Flexibility

Other than the non-marketable portion of U.S. government bonds, most bonds can be traded in the secondary market, so flexibility is actually fairly good. That said, non-marketable bonds may have redemption requirements—for example, I Bonds must be held for at least one year—so be sure to think it through before buying.

If you want to trade marketable Treasury securities, you first need to transfer the bonds to the bank, broker, or dealer through which you want to trade them. You can start the process in Treasury Direct and then complete and mail the required form.

How you transfer a bill to a bank, broker, or dealer depends on whether you hold the bill in TreasuryDirect or Legacy Treasury Direct.

  • For a bill held in TreasuryDirect:
    • Go to "Manage Direct"
    • Choose "Transfer securities"
    • Identify the bill or bills you want to transfer
    • Choose "External Transfer"
    • Click the link for FS Form 5511,"TreasuryDirect Transfer Request"
    • Complete FS Form 5511 and mail it as directed on the form
  • For a bill held in Legacy Treasury Direct, complete "Security Transfer Request"

    (FS Form 5179) and mail it as directed on the form.

If you originally bought the bond through an investment platform, you should generally be able to trade it directly there.

Fees

If you hold bonds directly, there are generally no additional fees. If you invest in bonds through a bond fund, the fund may charge management fees. If you trade bonds in the secondary market, there may also be transaction fees.

Taxes

Bond taxation is a bit more complicated than CD taxation because different types of bonds may have special tax rules.

Interest Tax

First, consider only the case where you hold a bond to maturity and do not trade it. The interest generated by the bond each year is taxable and should be reported as interest income, which effectively gets added directly to your total income. Depending on your income, the tax rate may range from 10% to 37%. Since each bond pays interest on a different schedule, you only need to consider the total interest paid during the tax year you are filing for. If the bond pays only at maturity, then you report the interest in the tax year when you receive it at maturity. Note that for nonresidents (for example, students who have been in the U.S. for fewer than 5 years), there is no interest tax.

Some bonds have special tax rules, including:

  • Savings bonds and treasury bonds (U.S. government bonds): Federal tax only; no state tax
  • Municipal bonds: No federal tax or state tax
  • Zero-coupon bonds: Even though there is no stated coupon payment, the IRS allocates imputed interest to each year. In other words, even if you did not actually receive interest, you still need to pay tax based on the estimated interest.
  • Bonds in a tax-advantaged account: If you invest in bonds in a Roth IRA or Roth 401(k), the interest is also not counted until you withdraw, so there is no need to report it every year.
  • Bonds used for special purposes: If your bond proceeds are used for higher education or certain other purposes (other qualifications) after the bond matures, you may not have to pay tax.

Capital Gains Tax

If you trade bonds in the secondary market, the income is no longer treated as interest income but instead becomes capital gains, so tax filing is similar to stocks. Capital gains are divided into long-term and short-term categories, each with different tax rates. For details, see:

Summary

Most bonds are similar to CDs and are not especially exciting. And considering the FDIC issue, CDs may still look a little better. But some specialized bonds—especially U.S. Treasuries—are still worth considering. These Treasury products come with annual purchase limits, but they can be quite helpful for personal finance, and you can buy a little each year to earn steady interest income.

For other low-risk ways to manage your money, see: