Types of Bonds

A bond is a security instrument which acknowledges that the issuer has borrowed money and must repay it to the bondholder at a specified rate of interest over a predetermined period of time. These securities are referred to as debt obligations, contrasted with stocks, which represent ownership in a corporation. Bonds fall into the three categories of their issuers: corporations; the U.S. government and its agencies; and states, municipalities, and other local governments. Each has features and advantages which should be evaluated when deciding upon which type of bond best suits your investment needs.

The interest that a bond pays is called its yield; it’s expressed as a percentage of the bond’s face value. For example, a $5,000 bond with an 8% yield would pay $400 in interest per year. Because the income from a bond doesn’t change from year to year, it’s known as a fixed-income security. The interest can be paid out in yearly payments, or coupons; bonds which do not pay out yearly but pay the principal and all accumulated interest at maturity are known as zero-coupon bonds.

It is important to be aware of the fundamental relationship between a bond’s yield and its maturity (the predetermined time for payback). Longer maturities generally translate to higher yields, because of the increased potential that, over time, a rise in interest rates will lower the bond’s price. Generally, bond prices move in the opposite direction of interest rates. If rates go up, the price of bonds declines. Conversely, when interest rates go down, bond prices rise.

Corporate bonds are issued by corporations to finance their long-term capital projects and are paid back within a specified period of time (the bond’s maturity). To help investors in making a judgment about the creditworthiness of a bond, independent rating services evaluate the issuing company’s ability to repay the bond. Generally speaking, the interest rate that the bond pays reflects its relative safety. Usually, the higher the quality of the bond, the lower the interest rate, because the risk to the investor is perceived to be lower.

U.S. government bonds can take the form of Treasury securities or securities of certain U.S. agencies, such as those of the Government National Mortgage Association (GNMA), which are called “Ginnie Maes”. These instruments are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. As such, these bonds are considered to be “risk-free”. Depending on their length of maturity, Treasury issues are called U.S. Treasury bills (T-Bills) if maturities ranges from 90 days to one year, U.S. Treasury notes (T-Notes) for maturities of one-to ten years, and U.S. Treasury bonds (T-Bonds) if maturities are from ten- to thirty years.

Municipal bonds are issued by state and local governments, often to finance specific projects such as highways, schools, recreational facilities, and the like. While they typically pay lower interest rates than corporate bonds, the interest income is generally exempt from federal income tax and frequently from state and local taxes, as well. Thus, a lower-yield municipal bond could actually be more attractive than a higher-paying taxable instrument when the relative tax consequences are figured into the comparison, especially in the higher income tax brackets.

For a further discussion of the uses and advantages of bonds, please read the article Advantages of Bonds.