Types of Bonds
Bonds are known as "fixed-income" securities because the amount of income the bond will generate each year is "fixed," or set, when the bond is sold. No matter what happens or who holds the bond, it will generate exactly the same amount of money.
There are four basic kinds of bonds, all defined by who is selling the debt.
- The federal government. U.S. government bonds are called Treasuries because they are sold by the Treasury Department. Treasuries come in a variety of different "maturities," or lengths of time until maturity, ranging from three months to 30 years. Various types of Treasuries include Treasury notes, Treasury bills, Treasury bonds, and inflation-indexed notes. These all vary based on maturity and amount of interest paid. The Treasury Department also sells savings bonds as well as other types of debt through the Bureau of the Public Debt. Treasuries are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay.
- Other government agencies. Some government agencies and quasi-government agencies like the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae) sell bonds backed by the full faith and credit of the U.S. for specific purposes, such as funding home ownership.
- Corporate bonds. Companies sell debt through the public securities markets just as they sell stock. A company has a lot of flexibility as to how much debt it can issue and what interest rate it will pay, although it must make the bond attractive enough to interest investors or no one will buy them. Corporate bonds normally carry higher interest rates than government bonds because there is a risk that the company could go bankrupt and default on the bond, unlike the government, which can just print more money if it really needs it. High-yield bonds, also known as junk bonds, are corporate bonds issued by companies whose credit quality is below investment grade. Some corporate bonds are called convertible bonds because they can be converted into stock if certain provisions are met.
- State and local governments (munis). Because state and local governments can go bankrupt (ask the holders of Orange County, California, bonds if you don't believe that one), they have to offer competitive interest rates just like corporate bonds. Unlike corporations, though, the only way that a state can get more income is to raise taxes on its citizens, always an unpopular move. As a way around this problem, the federal government permits state and local governments to sell bonds that are free of federal income tax on the interest paid. State and local governments can also waive state and local income taxes on the bonds, so even though they pay lower rates of interest, for borrowers in high tax brackets the bonds can actually have a higher after-tax yield than other forms of fixed-income investments.
The type of lender will determine many of a bond's features. But there are other characteristics to consider besides the lender.