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Government Bonds
In general, fixed-income securities are classified according to the length
of time before maturity. These are the three main categories:
Bonds - debt securities maturing in more than 10 years.
Bills - debt
securities maturing in less than one year.
Notes - debt securities maturing in one to 10 years.
Marketable securities from the U.S. government - known collectively as
Treasuries - follow this guideline and are issued as Treasury bonds,
Treasury notes and Treasury bills (T-bills). Technically speaking, T-bills
aren't bonds because of their short maturity. (You can read more about
T-bills in our Money Market tutorial.) All debt issued by Uncle Sam is
regarded as extremely safe, as is the debt of any stable country. The debt
of many developing countries, however, does carry substantial risk. Like
companies, countries can default on payments.
Municipal Bonds
Municipal bonds, known as "munis", are the next progression in terms of
risk. Cities don't go bankrupt that often, but it can happen. The major
advantage to munis is that the returns are free from federal tax.
Furthermore, local governments will sometimes make their debt non-taxable
for residents, thus making some municipal bonds completely tax free. Because
of these tax savings, the yield on a muni is usually lower than that of a
taxable bond. Depending on your personal situation, a muni can be a great
investment on an after-tax basis.
Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations
have a lot of flexibility as to how much debt they can issue: the limit is
whatever the market will bear. Generally, a short-term corporate bond is
less than five years; intermediate is five to 12 years, and long term is
over 12 years. Corporate bonds are characterized by higher yields because
there is a higher risk of a company defaulting than a government. The upside
is that they can also be the most rewarding fixed-income investments because
of the risk the investor must take on. The company's credit quality is very
important: the higher the quality, the lower the interest rate the investor
receives. Other variations on corporate bonds include convertible bonds,
which the holder can convert into stock, and callable bonds, which allow the
company to redeem an issue prior to maturity.
Zero-Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued
at a considerable discount to par value. For example, let's say a
zero-coupon bond with a $1,000 par value and 10 years to maturity is trading
at $600; you'd be paying $600 today for a bond that will be worth $1,000 in
10 years.
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