There are a number of different types of bonds and bond funds that investors can pick for their individual retirement accounts (IRAs). The main categories of bonds include U.S. Treasuries, corporate bonds, high-yield bonds, and municipal bonds. Options for bond funds include bond mutual funds and bond ETFs. Investors may be able to realize significant tax benefits by including bonds in their portfolios. The following are some considerations for investors when picking bonds for their portfolios.
When it comes to choosing what assets to put into your retirement account, the tax-treatment and benefits of each account will be instructive. It's all about asset location. For instance, Roth IRAs are funded with after-tax dollars and grows tax-exempt. It would thus be redundant to fund that account with tax-free municipal bonds. Instead, bonds with high yields (interest rates) should be put in a Roth IRA where the interest income will never be taxed.
- A well-diversified investment portfolio should have an allocation to bonds, which are often less volatile than stocks and generate interest income.
- Understanding the tax structure of your retirement account will help you pick which type of bonds are most appropriate.
- Treasury bonds issued by the government are the least risky but also lowest yielding, while corporate and junk bonds are riskier but generate a potentially greater return.
Tax Advantages of Bonds in IRAs
IRAs allow investors to contribute money for retirement on a pretax basis, while earnings are tax-deferred until you withdraw them in retirement. There are significant tax advantages to holding bonds in IRAs.
Bonds are generally taxed at a higher rate than stocks. If bonds are not held in an IRA, income from them is taxed as ordinary income. The federal tax rate for ordinary income can be as high as 37% versus a long-term capital gains rate of up to 20% for stocks.
IRAs are especially attractive for holding Treasury Inflation-Protected Securities (TIPS). TIPS are indexed to inflation to prevent investors from holding negative investments. The par value for these bonds rises with the inflation measured by the Consumer Price Index (CPI). They are issued with five-, 10-, and 30-year maturities.
The exception is municipal bonds. These pay tax-exempt interest, which is one of their main benefits. They offer a lower yield spread because they are tax-free. There is no additional tax benefit to be gained by holding them in an IRA. As such, they are better off being held in a regular account.
U.S. Treasuries for Your IRA
For low-risk investors, U.S. Treasuries offer the greatest deal of security. Treasuries are backed by the full faith and credit of the U.S. The U.S. has never defaulted on its debt, making these investments essentially risk free.
The government sells bonds with different maturities to the public to borrow money. The most common Treasuries are the three-month Treasury bill (T-bill), the five-year Treasury note (T-note), the 10-year T-note, and the 30-year Treasury bond (T-bond). Since the 2008 financial crisis, the Federal Reserve has kept interest rates near-record lows. This has kept yields for Treasuries quite low, making them less attractive for investors who are seeking higher returns.
There are a number of bond ETFs investors can hold in their IRAs depending on the portion of the yield curve in which the investor wants exposure. The iShares 20+ Year Treasury Bond ETF (TLT) provides an easy way to gain exposure to long-term U.S. T-bonds. The fund tracks the investment results of an index of bonds with maturities in excess of 20 years. The fund has over $17 billion in assets under management (AUM) and pays an annual distribution yield of 2.49% as of March 2020.
TLT is very liquid, with an average one-month daily trading volume of more than 10 million shares. Further, it has a very low expense ratio of 0.15%. It offers investors a good way to diversify other holdings that have more volatility and greater risk.
Corporate Bonds for Your IRA
Another option for an investor with higher risk tolerance is corporate bonds, which are issued by a corporation and backed by the ability of the company to pay its debt obligations. The corporation can use its physical assets as collateral for the bonds, but this is not as common.
Corporate bonds have more risk associated with them compared with government bonds. The corporation may encounter difficulties with its business or be impacted by an economic slowdown. There is a risk that a corporation may default on its debt obligations, and the bondholders do not get repaid.
Corporate bonds pay a higher rate of interest because of this increased risk. Some corporate bonds may have call provisions that allow the corporation to pay them off early. This benefits the corporations if interest rates go down, and they can refinance their debt at lower rates. Corporate bonds with callable provisions generally pay a higher rate of interest versus non-callable bonds due to the risk of the bonds being called. If the investor has the bond called, they are forced to reinvest coupon payments received at a lower interest rate.
There are good corporate bond ETFs available to investors. The iShares iBoxx Investment Grade Corporate Bond ETF (LQD) provides broad exposure to U.S. investment-grade corporate bonds. Investment-grade bonds have a high credit rating and generally, have the least amount of default risk. It has over $38 billion in AUM and pays a low expense ratio of 0.15% as of March 2020. With more than 2,005 holdings, the fund is extremely well-diversified, so there is much less risk of exposure to a corporate default.
This fund provides an easy way to gain exposure to corporate debt in a single investment vehicle.
High-Yield Bonds for Your IRA
High-yield bonds are appropriate only for those investors with a higher risk tolerance. High-yield bonds, also known as junk bonds, are non-investment-grade corporate bonds. This level of corporate debt has lower credit ratings because of the higher risk of default. As a result of the higher risk of default, these bonds pay more interest.
Although these bonds carry greater risk, they also have more potential upside. A company that goes from a non-investment-grade credit rating to an investment-grade credit rating often sees the price of its bonds increase. However, if a company declares bankruptcy, its bonds often have very little residual value.
There are also solid high-yield debt ETF options for investors. The iShares iBoxx High Yield Corporate Bond ETF (HYG) has over $18 billion in assets under management as of April 2020. It pays an annual distribution yield of more than 5%. It has a higher expense ratio of 0.49%, but this is not an unreasonable amount. It has a beta of 0.39, showing a higher correlation with the stock market than the other funds listed.
Beta is a measure of volatility or price fluctuations. A beta of one means a security moves with the overall market. A beta below one means that a security is less volatile while a beta above one is more volatile than the overall market.
HYG, for example, has 991 holdings in its portfolio. This diversification reduces but does not eliminate corporate default risk. There can be a high number of defaults during an economic slowdown.