When it comes to investing, you have two primary options: equities and debt instruments. Equities are things you own, such as stock or real estate. Debt instruments represent a loan from which you expect to receive a return of your principal with interest, such as a bank certificate of deposit or a municipal bond. In some cases debt instruments can also produce a capital gain or loss.
The federal government provides the safest place for your debt investments through the sale of Treasury bonds, bills, notes and other government-backed securities, because the interest and principal are backed by the full faith and credit of the United States government. The difference between these debt securities involves their maturity dates. Treasury notes might mature in a few days, while Treasury bills have varying maturity dates ranging from two to 10 years. Treasury bonds extend for 30 years. The interest on U.S. Treasury bonds, bills and notes is exempt from state income tax but is taxable on your federal income tax return.
You might not think of your savings account as an investment vehicle, but it is. A debt investment involves loaning your money to an institution or organization in exchange for the promise of a return of your principal plus interest. When you put money into your bank account, you are loaning money to the bank in exchange for a stated rate of interest. Since you can take money out of your demand deposit accounts any time you want, the interest rate is typically quite low. You can usually get a higher interest rate by agreeing to keep your money on deposit for a longer period, such as in a certificate of deposit. Bank deposits have the added protection of being insured up to maximum limits by the Federal Deposit Insurance Corporation.
Bonds are a common form of debt security. Just as the federal government borrows money by selling Treasury bonds, local municipalities and corporations borrow money by selling bonds. Municipal bonds typically have the added benefit of paying interest that is free from federal income taxes. Corporate bonds are fully taxable at both the federal and state level but usually pay a higher interest rate than either municipal or government bonds. Corporate and municipal bonds carry a higher investment risk, as they are not backed by the federal government or insured by the FDIC.
The primary way you earn money from debt investments is through collecting interest payments, but some debt instruments trade in the secondary market and can produce either capital gains or losses. For example, a bond with a face value of $1,000 will be redeemed by the issuer for $1,000 upon maturity, but its market price will fluctuate before maturity based on changes in the prevailing interest rate and in the issuer's credit rating. The market price of debt securities tends to move in the opposite direction of interest rates, so if prevailing interest rates rise, the market value of the debt security typically falls. If you buy a bond for less than its face value and later redeem it for its face value, the difference is a taxable capital gain, even if the security is a tax-free municipal bond.
Video of the Day
- tax forms image by Chad McDermott from Fotolia.com