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Types of Bonds

How High-Yield Bonds Are Taxed

As corporate debt instruments, high-yield bonds are subject to the same tax treatment for individuals as investment-grade corporate bonds, as described below. For advice about your specific situation, consult your personal tax advisor.

Interest The interest you receive from corporate bonds is subject to federal and state income tax. This interest is taxed as “ordinary income,” like wages.

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 up to a year from purchase, the gains are taxed at your ordinary rate. If you sell it more than a year after purchase, your capital gains are considered long-term and are currently taxed at a maximum rate of 20%. After December 31, 2000 if you sell a bond after holding it for more than 5 years, your gains will be taxed at a rate of 18%.

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.

Zero-coupon bonds Zero-coupon bonds are relatively rare in the high-yield market, although there are many zero/step-up bonds. Zero-coupon bonds pay no current interest. Instead, they pay all accrued interest out at maturity. Zero-coupon bonds are issued at prices well below par (maturity) value. A similar type of bond, known as an “original-issue discount” bond, is issued below par value and may pay out some interest.

The federal tax treatment of zero-coupon and original-issue-discount bonds is quite complicated, so if you plan to invest in them, first consult your tax advisor. During the time you own these bonds, you must pay tax each year on a portion of the discount, even if you do not receive any current interest income.

Tax-exempt high-yield bonds A category of tax-exempt high-yield bonds is not covered in this booklet. When lower-rated governments, municipalities and municipal agencies issue bonds, these are considered high-yield municipal bonds. Their interest may be exempt from federal income tax, as well as state and local income tax for residents of the state of issue. Consult your tax advisor for more information on tax-exempt high-yield bonds.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.