When you buy a bond, you are loaning money to the issuer in exchange for the promise of regular interest payments and a return of the face value of the bond upon maturity. Bonds can be categorized in a number of ways, including the length of time they continue to pay interest. Knowing the differences between a bond that matures in one year and one that matures in 20 years can help you make better investment decisions.
When a bond is first issued, its interest rate is determined in part by prevailing interest rates on similar types of securities being issued at the same time. Once the bond is issued, its market price will rise or fall in the opposite direction of prevailing interest rates. Since there is greater uncertainty about the long-term direction of interest rates, bonds with longer maturities, such as 20 years, must typically offer higher initial interest rates than comparable bonds with a one-year maturity to compensate investors for the additional risk.
The Internal Revenue Service considers all interest earned on bonds to be taxable income in the year it is earned, unless it is exempted from taxation by law. It doesn't matter if your bond has a 20-year maturity or a one-year maturity; the interest will be taxed as ordinary income. This rule has some exceptions. The interest on municipal bonds is typically exempt from federal income taxes, and the interest on U.S. Treasury securities, such as T-bonds, is exempt from state and local income taxes. You can defer paying taxes on the interest earned by 20-year Series EE U.S. savings bonds until they mature.
Safety and Stability
Bonds are typically classified as long term, short term or intermediate term, although different organizations use different definitions for each category. The Securities Industry and Financial Markets Association refers to bonds with a maturity of five years or less as short term and those with maturities of 12 years or more as long term. Maturities between those ranges are intermediate term. Bonds with short-term maturities typically offer lower returns but are considered more safe and stable because the issuer must repay the principal sooner. Long-term bonds involve greater risk and usually provide a higher return.
The choice between investing in a one-year bond or a 20-year bond depends on your risk tolerance and how soon you want your principal returned. An active secondary market exists for government, corporate and municipal bonds, so you could sell your bond before it matures. Since market prices for bonds fluctuate, the sale might result in a capital gain or loss.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.