All that you need to know about Bond Funds and Taxation

Many investors who want to reap the returns available in the corporate bond market may buy shares in bond mutual funds instead of individual bonds – or in addition to individual bonds. They do so for the same reasons investors have flocked to mutual funds of all kinds in recent years – diversification, professional management, modest minimum investments, automatic dividend reinvestment and other convenience features.

Bond Funds

Diversification is an especially important advantage of bond funds. Many investors in individual bonds buy only a few securities, thus concentrating their risk. A fund manager, by contrast, spreads credit risk, interest-rate risk and, indeed, all other kinds of risk, over many bonds. Different issuers, sectors, credit ratings, coupons and maturities are all represented in a diversified portfolio.

However, lower risk does not mean no risk. All the underlying risks that affect bonds affect bond funds – but not as sharply. You should be aware that prices of bond fund shares fluctuate inversely with interest rates, just as individual bonds’ prices do, and when you sell fund shares, they may be worth more or less than you paid for them.

How Corporate Bonds are Taxed
The following basic information addresses the tax aspects of investing in corporate bonds. For advice about your specific situation, you should consult your tax adviser.

Interest
The interest you receive from corporate bonds is subject to federal and state income tax. (If you own shares in bond mutual funds, your interest income will come to you in the form of “dividends” from the fund, but these are fully taxable, too.)

Gains and Losses
You may generate capital gains on a corporate bond if you sell it at a profit before it matures. If you sell it within less than a year from purchase, the gains are taxed at your ordinary rate. If you sell it after a year, your capital gains are considered long-term and are currently taxed at a maximum rate of 28%.

Conversely, if you sell a bond for less than you paid, you may incur a capital loss. You may offset an unlimited amount of such losses dollar for dollar against capital gains you have realized on other investments (bonds, stocks, mutual funds, real estate, etc.). If your losses exceed your gains, you may currently deduct up to $3,000 of net capital losses annually from your ordinary income. Any capital losses in excess of $3,000 are carried forward and can be used in future years. (These rules apply to the sale of shares in bond funds as well as to individual bonds.)

Original-Issue Discount
When bonds are issued at substantially less than par (face) value, the difference between the face amount and the initial offering price is known as original-issue discount. Zero-coupon bonds are the best-known variety of this category of bonds.

The tax treatment of original-issue-discount bonds is particularly complicated, so if you plan to invest in them, it is essential to consult your tax attorney or adviser. During the time you own original-issue-discount bonds, you will pay tax each year on a portion of the discount (even though you do not receive it).

However, if you hold them to maturity, you do not pay capital gains or other taxes on the amount by which the face value you receive exceeds the discounted amount you paid for the bonds. The reason is that you paid taxes on that excess incrementally each year that you held the bonds.