Understanding different types of bonds
Weighing the risks and benefits when investing in the bond market
U.S. Treasuries are the safest bonds of all because the interest and principal payments are guaranteed by the "full faith and credit" of the U.S. government. Interest is exempt from state and local taxes, but not from federal tax. Because of their almost total lack of default risk, Treasuries carry some of the lowest yields around.
Treasuries come in several flavors:
- Treasury bills, or "T-bills," have the shortest maturities - 13 weeks, 26 weeks, and one year. You buy them at a discount to their $10,000 face value and receive the full $10,000 at maturity. The difference reflects the interest you earn.
- Treasury notes mature in two to 10 years. Interest is paid semiannually at a fixed rate. Minimum investment: $1,000 or $5,000, depending on maturity.
- Treasury bonds have the longest maturities at 10 years. As with Treasury notes, they pay interest semiannually, and are sold in denominations of $1,000.
- Zero-coupon bonds, also known as "strips" or "zeros," are Treasury-based securities that are sold by brokers at a deep discount and redeemed at full face value when they mature in six months to 30 years. Although you don't actually receive your interest until the bond matures, you must pay taxes each year on the "phantom interest" that you earn (it's based on the bond's market value, which usually rises steadily during the time you hold it). For that reason, they are best held in tax-deferred accounts. Because they pay no coupon, zeros can be highly volatile in price.
- Inflation-indexed Treasuries. These pay a real rate of interest on a principal amount that rises or falls with the consumer price index. You don't collect the inflation adjustment to your principal until the bond matures or you sell it, but you owe federal income tax on that phantom amount each year - in addition to tax on the interest you receive currently. Like zeros, inflation bonds are best held in tax-deferred accounts.
- Mortgage-backed securities represent an ownership stake in a package of mortgage loans issued or guaranteed by government agencies such as the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corp. (Freddie Mac), and Federal National Mortgage Association (Fannie Mae). Interest is taxable and is paid monthly, along with a partial repayment of principal. Ginnie Mae has always been backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac, on the other hand, have been under government control since Sept. 2008, putting Uncle Sam on the hook to guarantee their mortgage-backed securities. The volatile mortgage market in late 2007 taught investors that risks for these kinds of bonds are by no means negligible. Mortgage-backed securities generally yield between 2% and 4% more than Treasuries of comparable maturities. Minimum investment: typically $25,000.
- Corporate bonds pay taxable interest. Most are issued in denominations of $1,000 and have terms of one to 20 years, though maturities can range from a few weeks to 100 years. Because their value depends on the creditworthiness of the company offering them, corporates carry higher risks and, therefore, higher yields than super-safe Treasuries. Top-quality corporates are known as "investment-grade" bonds. Corporates with lower credit quality are called "high-yield," or "junk," bonds. Junk bonds typically pay higher yields than other corporates.
- Municipal bonds, or "munis," are one of America's favorite tax shelters. They are issued by state and local governments and agencies, usually in denominations of $5,000 and up, and mature in one to 30 or 40 years. Interest is exempt from federal taxes and, if you live in the state issuing the bond, state and possibly local taxes as well. (Note that there are exceptions). The capital gain you may make if you sell a bond for more than it cost you to buy it is just as taxable as any other gain; the tax-exemption applies only to your bond's interest.
Munis generally offer lower yields than taxable bonds of similar duration and quality. Because of their tax advantages, though, their after-tax returns are often higher than equivalent taxable bonds for people in the 28% federal tax bracket or above.
To compare taxable and tax-free yields, use our tax-equivalent yield converter.