Types of bonds
Companies can issue bonds, but most bonds are issued by governments. Because governments are generally stable and can raise taxes if needed to cover debt payments, these bonds are typically higher-quality, although there are exceptions.
U.S. Treasuries
These are considered the safest possible bond investments.
You'll have to pay federal income tax on interest from these bonds, but the interest is generally exempt from state tax. Because they're so safe, yields are generally the lowest available, and payments may not keep pace with inflation. Treasuries are extremely liquid.
Certain types of Treasuries have specific characteristics:
- Treasury bills have maturities of 1 year or less. Unlike most other bonds, these securities don't pay interest. Instead, they're issued at a "discount"—you pay less than face value when you buy it but get the full face value back when the bond reaches its maturity date.
- Treasury notes have maturities between 2 years and 10 years.
- Treasury bonds have maturities of more than 10 years—most commonly, 30 years.
- Treasury Inflation-Protected Securities (TIPS) have a return that fluctuates with inflation.
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- Separate Trading of Registered Interest and Principal of Securities (STRIPS) are essentially Treasuries that have had their coupon payments "stripped" away, meaning that the coupon and face value portions of the bond are traded separately.
- Floating rate notes have a coupon that moves up and down based on the coupon offered by recently auctioned Treasury bills.
Read more about Treasury securities
Government agency bonds
Some agencies of the U.S. government can issue bonds as well—including housing-related agencies like the Government National Mortgage Association (GNMA or Ginnie Mae). Most agency bonds are taxable at the federal and state level.
These bonds are typically high-quality and very liquid, although yields may not keep pace with inflation. Some agency bonds are fully backed by the U.S. government, making them almost as safe as Treasuries.
Because mortgages can be refinanced, bonds that are backed by agencies like GNMA are especially susceptible to changes in interest rates. The families holding these mortgages may refinance (and pay off the original loans) either faster or slower than average depending on which is more advantageous.
If interest rates rise, fewer people will refinance and you (or the fund you're investing in) will have less money coming in that can be reinvested at the higher rate. If interest rates fall, refinancing will accelerate and you'll be forced to reinvest the money at a lower rate.
Municipal bonds
These bonds (also called "munis" or "muni bonds") are issued by states and other municipalities. They're generally safe because the issuer has the ability to raise money through taxes—but they're not as safe as U.S. government bonds, and it is possible for the issuer to default.
Interest from these bonds is free from federal income tax, as well as state tax in the state in which it's issued. Because of the favorable tax treatment, yields are generally lower than those of bonds that are federally taxable.
Read more about municipal bonds
Corporate bonds
These bonds are issued by companies, and their credit risk ranges over the whole spectrum. Interest from these bonds is taxable at both the federal and state levels. Because these bonds aren't quite as safe as government bonds, their yields are generally higher.
High-yield bonds ("junk bonds") are a type of corporate bond with low credit ratings.
As a seasoned financial expert with a deep understanding of investment instruments, let's delve into the intricacies of the various types of bonds mentioned in the article.
U.S. Treasuries:
1. Treasury Bills (T-Bills):
- Short-term maturity of 1 year or less.
- Issued at a discount, no regular interest payments.
- Face value repaid at maturity.
2. Treasury Notes:
- Intermediate-term maturities between 2 and 10 years.
- Pay periodic interest and return principal at maturity.
3. Treasury Bonds:
- Long-term maturities exceeding 10 years, commonly 30 years.
- Regular interest payments and face value returned at maturity.
4. Treasury Inflation-Protected Securities (TIPS):
- Guard against inflation.
- Returns fluctuate with changes in the Consumer Price Index (CPI).
- Interest payments adjusted for inflation.
5. Separate Trading of Registered Interest and Principal of Securities (STRIPS):
- Treasuries with coupon payments separated from the principal.
- Allows trading of coupon and face value portions independently.
6. Floating Rate Notes:
- Interest rates tied to recent Treasury bill auctions.
- Coupon payments adjust based on market rates.
Government Agency Bonds:
1. Government National Mortgage Association (GNMA or Ginnie Mae):
- Agency bond issuer related to housing.
- Most agency bonds taxable at federal and state levels.
- Some agency bonds fully backed by the U.S. government.
2. Interest Rate Risks:
- Susceptibility to changes in interest rates.
- Mortgage refinancing affects cash flows.
- Impact on reinvestment rates in varying interest rate environments.
Municipal Bonds:
1. Issuers:
- Issued by states and municipalities.
- Generally safe due to the ability to raise funds through taxes.
2. Tax Treatment:
- Interest income exempt from federal income tax.
- State tax exemption if issued within the state.
3. Risk:
- Not as secure as U.S. government bonds.
- Potential for default by the issuer.
4. Yield:
- Generally lower yields due to favorable tax treatment.
Corporate Bonds:
1. Issuers:
- Issued by companies across credit risk spectrums.
2. Taxation:
- Interest taxable at federal and state levels.
3. Credit Risk:
- Yields higher than government bonds due to higher risk.
- High-yield bonds (junk bonds) have low credit ratings.
Inflation:
- A general increase in the prices of goods and services.
- TIPS are designed to protect against the erosive effects of inflation.
Liquidity:
- The ease and speed at which an investment can be sold at a fair price.
- Treasuries are highly liquid, easily convertible to cash.
- Liquidity is crucial for quick and efficient investment transactions.
This comprehensive overview illustrates the diverse landscape of bonds, each with its unique characteristics, risks, and tax implications. Understanding these nuances is crucial for making informed investment decisions tailored to individual financial goals and risk tolerances.
