Bonds are issued by federal, state, and local governments; agencies of the U.S. government; and corporations. There are three basic types of bonds: U.S. Treasury, municipal, and corporate.
Bonds, bills, and notes issued by the U.S. government are generally called “Treasuries” and are the highest-quality securities available. They are issued by the U.S. Department of the Treasury through the Bureau of Public Debt. All treasury securities are liquid and traded on the secondary market. They are differentiated by their maturity dates, which range from 30 days to 30 years. One major advantage of Treasuries is that the interest earned is exempt from state and local taxes. Treasuries are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, so there is little risk of default.
Treasury bills (T-bills) are short-term securities that mature in less than one year. They are sold at a discount from their face value and thus don’t pay interest prior to maturity.
Treasury notes (T-notes) earn a fixed rate of interest every six months and have maturities ranging from 1 to 10 years. The 10-year Treasury note is one of the most quoted when discussing the performance of the U.S. government bond market and is also used as a benchmark by the mortgage market.
Treasury bonds (T-bonds) have maturities ranging from 10 to 30 years. Like T-notes, they also have a coupon payment every six months.
Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds. The principal value of TIPS is adjusted by changes in the Consumer Price Index. They are offered in maturities of 5, 10, or 30 years.
In addition to these Treasury securities, certain federal agencies also issue bonds. The Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corp. (Freddie Mac) issue bonds for specific purposes, mostly related to funding home purchases. These bonds are also backed by the full faith and credit of the U.S. government.
Municipal bonds (“munis”) are issued by state and local governments to fund the construction of schools, highways, housing, sewer systems, and other important public projects. These bonds tend to be exempt from federal income tax and, in some cases, from state and local taxes for investors who live in the jurisdiction where the bond is issued. Munis tend to offer competitive rates but with additional risk because local governments can go bankrupt.
Note that, in some states, investors will have to pay state income tax if they purchase shares of a municipal bond fund that invests in bonds issued by states other than the one in which they pay taxes. In addition, although some municipal bonds in the fund may not be subject to ordinary income tax, they may be subject to federal, state, and local alternative minimum tax, if an investor sells a tax-exempt bond fund at a profit, there are capital gains taxes to consider.