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Types of Investments - Bonds

What they are

A bond is essentially a loan you give to a government or an institution. In exchange, the issuer of the bond agrees to pay you a pre-set, regular interest rate payment for a fixed amount of time. At the end of the term, the issuer (who borrowed the money) agrees to pay you back the bond’s par value.

How they work

While bonds are considered less risky than stocks, investing risks vary depending on the type of bond you buy. The interest rate is based on a number of factors, including the risk of the loan: The higher the risk, the higher the interest rate.

All bonds carry market risk, and if you sell the bond before the end of its term, you may not recoup the principal amount you paid. In addition, it’s important to note that the issuer may default on either the interest payments or the payback amount, or both. Keep in mind that interest rate fluctuations affect bond prices. When interest rates fall, bond prices tend to rise, and when interest rates rise, bond prices tend to fall.

An important part of your portfolio

Even if interest rates trend up, bonds can help add stability to your portfolio, potentially helping to:

  • Reduce fluctuations in the overall value of your portfolio
  • Contribute to meeting your income needs
  • Prepare for future expenses (such as college and retirement)

Types:

Federal bonds are issued by the federal government, while municipal bonds are issued by state governments or local municipalities. Within these 2 categories are tax-exempt and taxable bonds.

Tax-Exempt Bonds

Tax-exempt bonds are usually bonds issued by a municipal, county, or state government (called municipal or "muni" bonds). Bond interest payments are exempt from federal income tax and, in some cases, state and local income tax. Tax-exempt bonds may fit within your overall investment strategy, depending on your tax bracket and investment goals.

Taxable bonds

You’ll pay taxes on interest payments from taxable bonds. Some examples include:

  • Corporate bonds
  • Government-sponsored enterprises (although, some are state and local tax-exempt)
  • Taxable municipal bonds (although, they may be exempt from state taxes if you live in the state where the bond is issued)
  • U.S Treasury bonds (but they’re exempt from state and local taxes)
  • Zero-coupon bonds (although, some are exempt from state and local taxes)
How to invest in bonds

Aside from Treasuries, which can be purchased directly from the U.S. government, most bonds must be purchased through a brokerage account or an investment vehicle such as a mutual fund. If you prefer to invest through Wells Fargo Advisors, you can invest online on your own or get help from a Financial Advisor.

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Interest rate payment

When money is borrowed, interest is typically calculated as a percentage of the principal, which is the amount owed to the lender. The percentage of the principal paid over time (typically a year) is called the interest rate.