Most bonds you'll come across have been issued by one of three groups: the U.S. government, state and local governments or corporations. But to confuse things, these entities issue many different types of bonds that run the gamut in terms of risk and reward. Here's a quick introduction to the ones you'll encounter most often.
U.S. Government Bonds
The bonds issued by Uncle Sam are called Treasurys. They're grouped in three categories.
Treasurys are widely regarded as the safest bond investments, because they are backed by "the full faith and credit" of the U.S. government. In other words, unless something apocalyptic occurs, you'll most certainly get paid back. Since bonds of longer maturity tend to have higher interest rates (coupons) because you're assuming more risk, a 30-year Treasury has more upside than a 90-day T-bill or a five-year note. But it also carries the potential for considerably more downside in terms of inflation and credit risk (see previous lecture).
Compared to other types of bonds, however, even that 30-year Treasury is considered safe. And there's another benefit to Treasurys: The income you earn is exempt from state and local taxes.
Municipal bonds are a step up on the risk scale from Treasurys, but they make up for it in tax trickery. Thanks to the U.S. Constitution, the federal government can't tax interest on state or local bonds (and vice versa). Better yet, a local government will often exempt its own citizens from taxes on its bonds, so that many munis are safe from city, state and federal taxes. (This happy state of affairs is known as being triple tax-free.)
These breaks, of course, come at a cost: Because tax-free income is so enticing to high-income investors, triple tax-free munis generally offer a lower coupon rate than equivalent taxable bonds. But depending on your tax rate, your net return may be higher than it would be on a regular bond.
Corporate bonds are generally the riskiest fixed-income securities of all because companies -- even large, stable ones -- are much more susceptible than governments to economic problems, mismanagement and competition. Cities do go bankrupt, but it's infrequent. Not so rare is the once-proud company brought low by foreign rivals or management missteps. Pan Am, LTV Steel and the Chrysler bankruptcies of 1979 come to mind.
That said, corporate bonds can also be the most lucrative fixed-income investment, since you are generally rewarded for the extra risk you're taking. The lower the company's credit quality, the higher the interest you're paid. Corporates come in several maturities:
The credit quality of companies and governments is closely monitored by two major debt-rating agencies: Standard & Poor's and Moody's. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings -- expressed as letters (Aaa, Aa, A, etc.) -- help determine the interest rate that company or government has to pay.
Corporations, of course, do everything they can to keep their credit ratings high -- the difference between an A rating and a Baa rating can mean millions of dollars in extra interest paid. But even companies with less-than-investment-grade (Ba and below) ratings issue bonds. These securities, known as high-yield, or "junk," bonds, are generally too speculative for the average investor, but they can provide spectacular returns.
Zero-coupon bonds are fixed-income securities that don't make interest payments each year like regular bonds. Instead, the bond is sold at a deep discount to its face value and at maturity, the bondholder collects all of the compounded interest, plus the principal.
Why would you want to do that? Zeros are usually priced aggressively and are useful for investors who are looking for a set payout on a given date, instead of a stream of payments that they have to figure out where to invest elsewhere. People saving for college tuition and retirement are the prime targets. The SmartMoney college portfolios (see our College Investing section) make use of zero-coupon Treasurys -- known as Treasury strips -- for two reasons. First, you can buy them in a maturity that matches the date your child will enter college. And, they generally have a slightly higher yield than a regular bond.
Zeros do have a tax drawback, however, unless you hold them in a tax-deferred retirement account or an education IRA. Since interest is technically earned and compounded semiannually, holders of zeros are obliged to pay taxes each year on the interest as it accrues. That means you have to pay the tax before you get the money, which might be a struggle for some investors.