Types of bonds

Treasury bonds

Bonds issued by the federal government are called Treasury bonds. Backed by the full faith and credit of the United States government, Treasuries are regarded as one of the safest bond investments. Interest income from Treasury bonds is exempt from state and local income taxes, but fully taxable at the federal level. 

Treasuries fall into three categories based on maturity:

1. Treasury bills—maturities from a few days up to one year
2. Treasury notes—maturities between one year and 10 years
3. Treasury bonds—maturities of more than 10 years

Choosing which of these is right for you depends on your time horizon and risk tolerance. Bonds with longer maturities often provide higher returns because they have more exposure to interest rate risk. And bonds with shorter maturities usually offer lower returns since they have less exposure to interest rate risk.

Municipal bonds

Municipal bonds, or “munis,” are typically issued by a state, city, or local government. Municipal bonds are considered riskier than Treasuries because there is a higher risk that a local government would default compared to the federal government.

Despite typically offering lower yields than other forms of taxable bonds, for many investors the federal income tax benefits alone make municipal bonds an attractive prospect. The federal government doesn’t tax interest accrued on municipal bond holdings. Also, local and state governments often exempt investors from taxes on the bonds they issue. This means municipal bonds may effectively be tax free, but make sure to check with your tax advisor on specific bonds and local tax laws.

Zero coupon bonds

A zero coupon bond is a fixed income security which, unlike most bonds, does not pay out periodic interest. Instead, it pays out the entire compounded interest, plus principal, at maturity. That required patience is acknowledged on the front end with deep discounts to the bond’s face value.

Governments, municipalities, and corporations issue zero coupon bonds, which are designed and priced to attract investors who prefer a single payout on maturity rather than a series of payments over a number of months or years.

Zero coupon bonds accrue interest on an annual basis and are taxed each year. In effect, zero coupon bond holders are required to pay income taxes on money to which they do not yet have access. One solution is to hold taxable zero coupon bonds in tax-advantaged accounts like IRAs. Note, zero coupon bonds issued by a municipality are generally exempt from federal, and sometimes local income tax, and are not typically held in IRAs.

Corporate bonds

Corporate bonds typically carry more risk than municipal or Treasury bonds but offer potentially higher returns. 

The reason corporate bonds are considered riskier than Treasury or municipal bonds is simple: Corporations are deemed to be less secure entities than federal, state, or local governments. For investors willing to do their due diligence, corporate bonds can prove to be a powerful investment vehicle.

Investors can select different corporate bonds according to their risk profile, using information from agencies such as Moody’s or Standard & Poor’s for ratings on the credit worthiness of a company. Ratings range from AAA (“Highest Quality”) to D (“In default”).

The maturities of corporate bonds typically fall into three buckets:

1. Short term—ranging from one to five years
2. Medium term—between five and 12 years 
3. Long term—in place for longer than 12 years