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Stock and Bond Glossary

Types of common stocks. Common stock investments offer two possible benefits. First, the company may pay dividends to its shareholders. Second, investors may benefit through capital appreciation - an increase of the share price of stock. Not all common stocks are the same, however. Some pay dividends, and some don't. Some have relatively stable prices, while others are more volatile. Most common stocks are classified into one of several categories.

Growth stocks. Investors buy growth stocks for capital appreciation. Because most growth companies are having to finance their growth and are involved in research, most or all of their earnings are reinvested in the company for future expansion. Therefore, while the shares of growth stocks have the prospect of increasing market value, they pay little, if any, dividends. The prices of growth stocks usually rise in value more than do those of other stocks, but they also decline in price more significantly.

Income stocks. Income stocks pay a higher-than-average dividend. Companies whose stocks fall into this category are typically in fairly stable industries (for example, telecommunications and utilities), have strong finances, and pay out a substantial portion of their earnings in dividends. Investors in income stocks also usually enjoy appreciation in the value of the stocks, and if the company's fortunes improve, the dividends will rise as well. While income stocks may not have the growth potential of growth stocks when prices are rising, they also tend not to decline in value as much as growth stocks when stock prices take a tumble.

Small company stocks. Small company stocks are more speculative than the other stock categories discussed here. In a sense, all common stocks are speculative, since they offer a variable rather than fixed return like bonds. But smaller company stocks are more speculative than large company stocks because smaller companies are more susceptible to changing economic conditions, competition, and declining stock markets. While you may be in a position to afford taking a "flyer" on one or a few small company stocks, most investors should avoid committing too much money to individual small company stocks. On the other hand, a small-company stock mutual fund is an important component of your investment portfolio.

International stocks. These are stocks of foreign companies. Many of the world's greatest companies are headquartered overseas. While buying shares of most foreign companies is very difficult for U.S. investors, many large overseas companies are listed on the U.S. stock exchanges and can be purchased in U.S. dollars. The shares of foreign companies that trade on U.S. stock exchanges are called ADRs, which stands for "American Depository Receipts". The easiest way to own international stocks is through an international stock mutual fund.

Types of bonds. Bonds pay a fixed rate of interest, but their principal value can fluctuate depending upon whether interest rates in general are rising or falling. Visualize a seesaw. When interest rates rise, bond prices fall; when interest rates fall, bond prices rise. Here are the three major categories of bonds.

U.S. government bonds. U.S. government bonds come in three varieties: Treasury bonds, mortgage-backed securities, and U.S. savings bonds.

Treasury securities are the means by which the U.S. government borrows money. (As you know, Uncle Sam is pretty good at borrowing money.) Treasury bonds are issued by the U.S. government and are considered the safest of all bonds, since they are backed by the government. Treasury securities that are issued with a maturity of greater than five years are called Treasury bonds. Treasury securities that are issued with maturities of between two and five years are called Treasury notes. Those of one year or less are called Treasury bills.

Treasury bills, notes, and bonds have a bit of a tax advantage. Interest earned on these bonds is not subject to state or local income taxes. There is one exception to this, which few investors realize. If you put a U.S. Treasury security or a U.S. Treasury mutual fund into a retirement account, interest which would otherwise have not been subject to state income taxes will become subject to state income taxes when you withdraw the money. The reason for this is that all income earned in a retirement account is subject to state income taxes. So you are better off keeping U.S. Treasury bonds outside of your retirement accounts in favor of corporate bonds, which are discussed below.

An interesting subspecies of U.S. Treasury securities, are zero-coupon bonds (also called "stripped Treasury bonds"). These bonds pay no interest along the way. Instead they are sold at a deep discount, which means they are sold at a price that is much lower than the maturity value of the bond. While you don't get any interest along the way, your profit comes at the end in the form of a big increase in the amount you are paid at maturity compared with your original investment.

The main advantage in zero-coupon bonds is that you are guaranteed a set rate of return insofar as the interest earned on these bonds is, in effect, reinvested at the original interest rate. Therefore, if interest rates decline you don't have to worry about reinvesting interest income at a lower rate. This automatic compounding also avoids your having to make decisions to invest the interest you would receive on a regular bond.

The main drawback of these "zeros" is that even though you are not receiving interest along the way, for tax purposes, the IRS assumes that you are, so you have to pay taxes on the "imputed" interest income. The upshot? These are good investments for tax-deferred retirement accounts such as IRAs and Keogh plans because you don't have to pay taxes on them before you retire. But is it worth putting zero coupon Treasuries into a retirement account if you are going to subject the interest to state income taxes on the interest when you withdraw the money? I think it is, because the other advantages of zero coupon Treasuries outweigh this drawback. But I still don't think you should put standard U.S. Treasury bonds or U.S. Treasury funds into a retirement account. Zeros are the exception.

Mortgage-backed securities have peculiar sounding names like Ginnie Mae, Fannie Mae, and Freddie Mac. These investments represent pools of mortgages. Their relatively high interest has been attracting a lot of investor interest, but the high investment minimums - typically $25,000 - mean that many of us can't afford them. If your pockets aren't that deep, you can get a piece of the mortgage-backed security action through a mortgaged-backed security mutual fund.

U.S. savings bonds are a popular and inexpensive way for savers to invest in government securities. Unfortunately, the U.S. Treasury made savings bonds much less attractive back in 1995 when they changed the rules. While you should hold onto older savings bonds that are still paying attractive interest, I would avoid investing in them anymore. There are just too many better investment opportunities elsewhere. The only exception to this might be if you are using U.S. savings bonds to build a college fund, and if you are quite confident that when your child enters college, your income will fall under the limits so that you will be able to cash in the savings bonds and not pay income taxes on the accumulated interest. But that requires a pretty clear crystal ball.

Municipal bonds are issued by state and municipal governments to borrow money. With few exceptions, the interest earned on municipal bond investments is exempt from federal income taxes, and in many instances from state and local taxes. Taxes take a heavy toll on your investments so it behooves you to take a close look at municipal bonds.

If you reside in a state that imposes high taxes on interest income, you should consider investing in municipals issued by your state. For example, if you reside in New York, interest on municipal securities issued by the state of New York or by New York municipalities would be exempt from both federal and state income taxes. These are known as "double tax-free" bonds.Interest on municipal securities issued by U.S. territories (the Territory of Guam and the Commonwealth of Puerto Rico) is generally exempt from both federal and state income taxes, no matter what state you reside in.

Because of the tax advantage, municipal bonds don't pay as high interest as U.S. government and corporate bonds. But that doesn't mean that munis are a raw deal. Au contraire. It's not the stated interest that the bond pays that counts. It's how much you have left after taxes are paid that really counts when you are investing in taxable accounts. (Of course, you would never put a municipal bond into a tax-advantaged retirement account because the bond interest itself is tax-exempt. If you put municipal bonds into a tax-deferred account, the interest that would otherwise have been tax-exempt would be subject to income taxes when you take the money out.

Comparing the interest paid on municipal bonds with the interest paid on U.S. government or corporate bonds is really quite simple. What you need to do is to calculate the "taxable equivalent yield" of a municipal bond. The formula for taxable equivalent yield enables you to compare a tax-free municipal bond investment to a taxable U.S. government or Treasury bond investment. Here's the formula:

Taxable equivalent yield  =  municipal bond interest rate

                                       (1 - your federal income tax bracket)

Let's look at an example.

EXAMPLE: Rhonda and Ron Rhoades are in the 28% federal income tax bracket. They're considering purchasing either a municipal bond paying 5% interest or a Treasury bond paying 6% interest. In order to accurately compare the yields, they must first compute the taxable equivalent yield on the municipal bond. Here's how they do it:

First, they need to convert their income tax bracket to its decimal equivalent: 28% becomes .28.

Second, they need to apply the above formula

Taxable equivalent yield  =  municipal bond interest rate

                                       1 - your federal income tax bracket
 
 

=          5%          =          5%          =          6.9%
        1   -   .28                .72
 
 
 
 

For the Rhodes, the taxable equivalent yield of the municipal bond investment turns out to be 6.9%, compared with 6% for the Treasury bond. The tax-free investment has a lower interest rate but it provides more interest income than the taxable Treasury bond.

How safe are municipal bonds? Most municipal bonds are pretty safe. After all, states and municipalities have a lot of power to raise money. But some municipalities have defaulted, so it behooves you to buy only higher rated municipal bonds. Most municipal bonds are rated by one or more of the ratings agencies, like Moody's and Standard & Poor's. Avoid any bonds that aren't rated.

Corporate bonds. Corporations issue a variety of bonds, but, thanks to the ratings agencies, it's a fairly easy job separating the junk bonds from the high-quality bonds. In fact, when you ask your broker to look for some corporate (or municipal) bonds, the first question she is likely to ask is: "What rating are you looking for?" Interest on corporate bonds is subject to both federal and state income taxes. Therefore, they usually pay somewhat higher interest than U.S. Treasury bonds (whose interest is exempt from state income taxes) and municipal bonds (whose interest is exempt from federal and, perhaps, state income taxes). The high interest that corporate bonds pay makes them particularly attractive for retirement accounts, since you don't have to pay income taxes currently on the interest you receive from the bonds.