THE STEADY STAPLES OF A WELL-BALANCED PORTFOLIO
are designed to eliminate a substantial portion of the outstanding debt prior to the bonds’ maturity.
While many corporate bonds can be called, or redeemed, prior to maturity, many companies now offer securities that give investors protection against their bonds being called for a specific period of time. Many investors are willing to take a lower rate of interest in exchange for some call protection or even noncallable bonds. The option of call protection changes with the condition of the economy.
Corporations may also have sinking funds established. These are designed to help the company retire its bonds before the maturity date. The firm will put the money earmarked for the bonds’ repayment into escrow, which it will then use to retire the bonds a few at a time.
The investment income derived from a corporate bond is fully tax- able for federal income tax purposes. It is also taxable for state income tax purposes in those states that have an income tax. The current inter- est paid on bonds (coupon rate) is taxed to the investor at ordinary income tax rates. If the bond was purchased at a premium (at a price higher than par value), the investor may choose to amortize the pre- mium over the remaining life of the bond. The investor may then use the amount amortized each year to reduce the bond’s taxable interest or as an itemized deduction, depending on when the bond was bought. Either way, the amortized amount acts as a way to reduce otherwise taxable ordinary income. It also reduces the investor’s tax basis in the bond.
If the investor elects not to amortize the premium, it will be added to the basis and will either reduce the capital gain (if the bond is sold for more than the cost) or produce a capital loss (if the bond is sold for less than the cost).
Municipal Bonds Municipal bonds, or “munis,” carry an important tax feature: the interest paid on these bonds are exempt from federal income tax, as well as state and local income tax in the state in which they are issued. This could mean significant savings in taxes that could other- wise be flowing to the government. Munis are especially attractive to investors whose tax brackets are quite high, therefore garnering them a greater after-tax return from tax-free interest than they would real- ize from taxable interest.