Bond Investment: Types of Bonds Bookmark and Share

Bonds can best be characterized by the types of entities that issue them. Most bonds can be characterized as either a U.S. Government Security, GSE Debt Security, Corporate Bond or a Municipal Bond.

U.S. Government Securities

U.S. Government Securities are commonly referred to as "Treasuries" because they are issued by the U.S. Treasury Department. They are backed by the "full faith and credit" of the U.S. Government and are as close to a "risk-free" investment one can find in practice. The U.S Treasury issues the following types of securities:

  • U.S. Treasury Bills

    • Maturity of less than 1 year
    • Issued in denominations of $100
    • Interest is paid at maturity (Equal to the difference between amount paid for bill and face value)

  • U.S. Treasury Notes

    • Maturity between 1 and 10 years
    • Issued in denominations of $100
    • Pay fixed coupons semi-annually

  • U.S. Treasury Bonds

    • Maturity greater than 10 years
    • Issued in denominations of $1000
    • Pay fixed coupons semi-annually

  • U.S. Treasury Inflation-Protected Securities (TIPS)

    • Principal is adjusted by changes in the Consumer Price Index (CPI)
    • Issued in maturities of 5, 10, and 20 years
    • Issued in denominations of $100
    • Pay fixed coupons semi-annually

  • U.S. Savings Bonds

    • Registered, Non-Marketable bond (Registered in names of individuals and cannot be sold in secondary market)
    • Earn interest for up to 30 years
    • Issued in denominations ranging from $50 to $10,000
    • Issued in 2 types: Series EE and Series I (Inflation-Protected)

Coupon interest on all securities issued by the U.S. Treasury is exempt from state and local taxes. Individuals can purchase Treasuries direct from the government. For more information about U.S. Goverment Securities and this program, please visit treasurydirect.gov.

GSE Debt Securities

Government-sponsored enterprises (GSE's) are financing entities created by Congress to fund loans to certain groups of borrowers such as homeowners, farmers, and students. The most commonly referenced GSE's are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) which fund loans to homeowners. In September 2008, as a result of the subprime mortgage crisis, both Fannie Mae and Freddie Mac were placed in the conservatorship of the Federal Housing Finance Agency (FHFA). As a result, the U.S. Treasury now owns 79.9% of both firms, has installed its own management, and has given both Fannie and Freddie access to the Treasury to fund its operations. Investors always assumed that GSE debt securities carried the implicit backing of the U.S Government. The conservatorship makes this "implicit" backing "explicit".

Other GSE's include the following:

  • Federal Home Loan Banks
  • Federal Farm Credit Banks
  • Sallie Mae
  • Tennessee Valley Authority

GSE Senior Debt is rated AAA/Aaa, but carry greater credit risk than and yield premium over securities issued by the U.S. Treasury despite implicit and explicit guarantees. The yield premium varies with market volatility, and the structure, maturity, and general supply and demand for the particular security. GSE's issue a variety of bills, notes, and bonds through their formal issuance programs. For more information on GSE Debt Securities, you can visit investinginbonds.

Corporate Bonds

Corporations finance themselves by selling either equity or debt. In the equity markets, corporations raise money in exchange for ceding fractional ownership of the company to investors. In the debt markets, companies raise money from investors by agreeing to pay a predetermined rate of interest. Essentially, by buying the bond from the corporation, you are lending your money to the corporation that issued it. The corporation promises to return your money, or principal, on the stated maturity date. Until that time, it pays you a stated rate of interest, or coupon payments. Corporate bonds are usually issued in denominations of $1,000 or $5,000, but unlike Treasuries or Municipal Bonds, their interest is fully taxable at the federal, state, and local levels. Compared with Treasuries or GSE Securities, corporate bonds usually pay a higher rate of interest due to them being more risky. Rating services like Standard & Poor's and Moody's assign a corporation's bonds ratings based on their perception of whether they will be able to meet scheduled interest and principal repayments. Typically, AAA has the lowest degree of risk, and D has the highest degree of risk. Bonds rated below BBB are usually referred to as "high-yield" bonds or "non-investment grade" due to a substantially higher degree of risk when compared with bonds rated AAA.

Municipal Bonds

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities to raise money to build schools, highways, hospitals and sewer systems, as well as many other projects for the public good. The majority of investors invest in municipal bonds because of their tax advantages. Municipal bond interest is exempt from federal income tax, and if you live in the locality issuing the bond, state and local taxes as well (Exceptions apply). However, not all municipal bonds are tax-exempt from federal tax. Bonds issued by municipal entities for the financing of certain activities that do not benefit the public at large are subject to federal income tax. Municipal bonds are also rated by services such as Standard & Poor's for credit quality. Historically, when compared with a corporate bond with the same rating, municipals have had a significantly lower default rate due to the taxing power of municipalities. However, the rating agencies are in the process of transitioning to a "global" rating scale with new criteria for both corporates and municipalities that is likely to diminish if not eliminate this bias.

Municipals usually offer lower yields when compared with corporate bonds because of their tax advantages and superior credit quality. When comparing a municipal bond with a corporate of similar credit quality, one needs to calculate the Taxable Equivalent Yield for the municipal. The taxable equivalent yield is calculated as follows:

Taxable Equivalent Yield = Tax-exempt yield divided by (1 - your marginal tax rate)

For example, if your marginal tax rate is 35% and the tax exempt yield is 5%, the taxable equivalent yield is 7.69%. Tax-free municipal bonds usually make less sense for people in lower tax brackets since the tax savings is directly dependent on the investor's marginal tax rate. The largest holders of municipal bonds as a group are individual investors or their proxies, who tend to be in the highest marginal tax bracket.

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