Types of bonds
E*TRADE from Morgan Stanley12/01/23
Which bonds may be right for your portfolio?
Bonds are typically issued by federal, state, or local governments, and corporations. As you might imagine, there’s a broad spectrum of potential risks and rewards among these different issuers.
To determine which bonds may be best suited to help you reach your financial goals, it’s important to understand the differences between each bond type.
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. Income from Treasury bonds is exempt from state and local taxes, but fully taxable on the federal level.
Treasuries fall into three categories based on maturity:
- Treasury bills—maturities from a few days up to one year
- Treasury notes—maturities between one year and 10 years
- Treasury bonds—maturities of more than 10 years
Which of these is right for you? That depends on your time horizon and appetite for risk. Bonds with longer maturities often provide higher returns because they have more exposure to interest rate risk. Bonds with shorter maturities usually offer lower returns since they have less exposure to interest rate risk.
Learn more about Treasury Bonds in E*TRADE’s Fixed Income Solutions Center (logon required).
Municipal bonds, or “munis,” are typically issued by a state, city, or local government. Municipal bonds are considered riskier than Treasuries. Why? There’s a higher risk that a local government would default compared to the federal government. While past performance does not indicate future results, munis have historically yielded 25% to 30% more than comparable Treasuries.
Despite typically offering lower coupon rates than other forms of taxable bonds, for many investors the tax benefits alone make municipal bonds an attractive prospect. The federal government doesn’t tax interest accrued through municipal bond holdings. Also, local and state governments often exempt investors from taxes on the bonds they issue. This means municipal bonds can effectively be tax free, but make sure to check with your tax advisor on specific bonds and local tax laws.
Learn more about Municipal Bonds in E*TRADE’s Fixed Income Solutions Center (logon required).
Zero coupon bonds
A zero coupon bond is a fixed income security which, unlike most bonds, doesn’t pay out periodic interest. Instead, it pays out the entire compounded interest, plus principal, at maturity. That required patience and forbearance 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 taxes on money to which they don’t 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 exempt from federal, and sometimes local tax, and are not typically held in IRA’s.
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, however, 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:
- Short term—ranging from one to five years
- Medium term—between five and 12 years
- Long term—in place for longer than 12 years
Learn more about Corporate Bonds in E*TRADE’s Fixed Income Solutions Center (logon required).
The fixed income market provides investors with a broad range of investment choices, enabling them to pursue strategies tailored to individual investment objectives. For investors looking to generate a predictable revenue stream for a diversified portfolio, bonds can provide a range of potential choices for different income requirements, tolerance for risk, and even tax strategies.
Let E*TRADE help
If you have any questions about bonds in general, or how to get started investing in them, please call us at 877-355-3237 to talk with an E*TRADE Fixed Income Specialist.