Three Options for Bond Investing - dummies

By Russell Wild

Below are three descriptions of specific types of bonds you might invest in: repos, treasury strips, and savings bonds for education. Umpteen different kinds of debt securities are issued by the U.S. Treasury.

Savings bonds, which can be purchased for small amounts and, until recently, came in certificate form (making for nice, if not slightly deceptive, bar mitzvah and birthday gifts), are but one kind.

In fact, when investment people speak of Treasuries, they usually are not talking about savings bonds but about larger-denomination bonds known formally as Treasury bills, Treasury notes, and Treasury bonds. All of these are now issued only in electronic (sometimes called book-entry) form.

No repose for investors in repos

Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most usually Treasury securities. The repo market is huge and complex, and most of the players are professional investment types.

For the average person with a mortgage to pay and mouths to feed, plunking money into repos is potentially dangerous business. But if risk is your middle name, you can enter the repo market through most large brokerage houses.

In essence, you buy a barrelful of Treasuries for little money. That’s known as leveraging. If you’re familiar with buying stocks on margin, it’s somewhat similar to that. But instead of banking on a company stock’s rise or fall, you’ll be banking on a rise or fall in interest rates, which in turn affects the price of Treasuries. If interest rates fall and bond prices go up, you can make out like a bandit.

If you’re wrong, however, you pay the piper. The broker will be lending you money to finance this speculation; make sure you ask for the repo rate of interest, which is generally less than the interest on other kinds of borrowing (as it should be, because the broker has your leveraged bonds as collateral).

Treasury strips

One kind of Treasury issue is available only through brokers, and that is called a strip. A Treasury strip is something of a strange duck. It is, in essence, a single interest payment of a bond that has been “stripped” from the rest of the bond.

For example, a $1,000, 20-year Treasury bond paying 3 percent offers 40 semiannual payments of $15 and one final principal payment of $1,000. If you want to invest in such a bond but have no need for immediate income, you may purchase a strip, which would offer you, say, only the final interest payment and the principal.

Strips are sold, like Treasury bills, at a deep discount. And that, to the individual investor, is their main advantage. You don’t need to invest very much to assure yourself a specific sum in the future. You may, for example, pay $300 for a strip that will pay you back $1,000 in 30 years, representing an annual interest rate of 4.095 percent.

Debt securities that work this way are called zero-coupon securities. Zero-coupons can be very volatile. If you need to cash out early, you may not get nearly what you’d anticipated. They are also not very tax friendly. You’re taxed on the interest as if you are paid annually, even though you get no cash. You may want to consider a strip only for your retirement account.

Savings bonds for education

The interest on savings bonds — both EE and I bonds — may be tax-free if you use the proceeds to pay for higher education expenses. The guidelines are fairly complex, and you’re eligible only if your income falls below a certain limit.

Currently, for single taxpayers, the tax exclusion begins to be reduced at a $70,100 modified adjusted gross income and is eliminated for adjusted gross incomes of $85,100 and above. For married taxpayers filing jointly, the tax exclusion begins to be reduced with a $105,100 modified adjusted gross income and is eliminated at $135,100. If you’re uncertain whether you qualify, speak to your tax adviser.