Types of Bonds

Updated on May 24, 2007.

Most bonds you'll come across have been issued by one of three groups: the U.S. government, state and local governments or corporations. But to confuse things, these entities issue many different types of bonds that run the gamut in terms of risk and reward. Here's a quick introduction to the ones you'll encounter most often.

U.S. Treasury bills — maturities from 90 days to one year

U.S. Treasury notes — maturities of more than one year to 10 years

U.S. Treasury bonds — maturities of more than 10 years

Treasurys are widely regarded as the safest bond investments, because they are backed by "the full faith and credit" of the U.S. government. In other words, unless something apocalyptic occurs, you'll most certainly get paid back. Since bonds of longer maturity tend to have higher interest rates (coupons) because you're assuming more risk, a 10-year Treasury has more upside than a 90-day T-bill or a five-year note. But it also carries the potential for considerably more downside in terms of inflation and credit risk (see previous lecture).

Compared with other types of bonds, however, even that 10-year Treasury is considered safe. And there's another benefit to Treasurys: The income you earn is exempt from state and local taxes.
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These breaks, of course, come at a cost: Because tax-free income is so enticing to high-income investors, triple tax-free munis generally offer a lower coupon rate than equivalent taxable bonds. But depending on your tax rate, your net return (or after-tax return) may be higher than it would be with a regular bond.
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That said, corporate bonds can also be the most lucrative fixed-income investment, since you're generally rewarded for the extra risk you're taking. The lower the company's credit quality, the higher the interest you're paid. Corporates come in several maturities:

Short term: one to five years

Intermediate term: five to 12 years

Long term: longer than 12 years

The credit quality of companies and governments is closely monitored by three major debt-rating agencies: Standard & Poor's, Moody's Investors Service and Fitch Ratings. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings — expressed as letters (Aaa, Aa, A, etc.) — help determine the interest rate that the company or government has to pay.

Corporations, of course, do everything they can to keep their credit ratings high — the difference between an A rating and a Baa rating can mean millions of dollars in extra interest paid. But even companies with less-than-investment-grade (Ba and below) ratings sell bonds to raise money. These securities, known as high-yield, or "junk," bonds, are generally too speculative for the average investor, but they can provide spectacular returns.
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Zeros are usually priced aggressively and are useful for investors looking for a set payout on a given date, instead of a stream of payments that they have to figure out where to invest elsewhere. They can, for example, be a handy tool for those approaching retirement.

Zeros do have a tax drawback, however. Since interest is technically earned and compounded semiannually, holders of zeros are obliged to pay taxes each year on the interest as it accrues. This means you have to pay the tax before you get the money, which might be a struggle for some investors.

This can be avoided by holding the bond in a tax-advantaged account, such as an IRA. Zero-coupon bonds issued by a municipality will also be federally (and in some cases state and locally) tax free, although like their traditional muni brethren, they'll offer lower coupon rate than a taxable bond.
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