Expert: Gina Boykin - 8/22/2007

Question
It seems to me that a good bond yields about 5 to 6 percent.  I now see "high yield" savings accounts that offer the same return.  Why invest in a bond, where there is risk, when you can put it in savings, and have no risk?


Answer
There are two advantages to investing in bonds.

#1 - Tax benefits for certain bonds.

The interest you make from Municipal bonds is free from federal taxes, and if you reside in the same area as the bond, can be free from state and local taxes as well.
The best way to determine the actual yield of a tax-free bond is the calculation below:

tax exempt yield
----(divided by)----
1 - tax bracket

For example, if you are in the 20% tax bracket, and the bond provides 5% interest, you would calculate:

5% / 1- 20% = 6.25%

The higher your tax bracket, the more attractive these bonds become.

#2 - Increase in price

If you expect interest rates to decline over time, the price of your bond will rise.  This is because your bond provides more interest than the "going rate".  You can make money, not only from the interest, but from the sale of your bond.  This only happens if you don't plan to hold it until it matures.  When a bond matures, the price is always equal to the original face value (which is good to remember if your bond goes down in price in the meantime).

If you expect interest rates to rise, this actually becomes a disadvantage.  However, as I stated earlier, you can overcome this by holding the bond until maturity.

Right now, bonds look great to a lot of investors because of the fluctuation in the stock market.  Most people have retirement accounts that cannot be placed in savings, so bonds are the best alternative.

If you have money that is not in a tax-benefit account though, you may very well decide that a plain vanilla savings account (or certificate of deposit) is the best place for you money.  I don't think anyone could find fault in that!