The Differences in Corporate, Municipal, and Federal Bonds

We've looked previously at why you might want to be a "bond girl." But if you're considering doing so, you might not know what to do next. One of the first things you need to decide are what kind of bonds might interest you.

As we mentioned in the previous post on bonds, a bond is basically an IOU that you buy from an issuer.  You loan them money, and they promise to pay you back (with interest) by a certain time on a specific schedule.

There are three main categories of bonds:

Corporate Bonds

A Corporate Bond is an IOU issued by a private corporation rather than a government agency or municipality.  Generally speaking, there are four main characteristics of Corporate Bonds:  (1) they are taxable; (2) they are generally issued in the amount of $1,000; (3) they come due all at once (have a “term maturity"); and (4) their prices are published in major newspapers, because they are traded on major exchanges.

Corporate bonds tend to be appealing because of their returns, but also present the highest chance of default. Thus they tend to be the highest risk, highest reward option.

Municipal Bonds

A Municipal Bond is one that is issued by a state or local government.  When the entity has a special project it would like to finance, or has some general governmental needs that must be paid for, they often issue these bonds to the public. 

The two main types of Municipal Bonds are General Obligation, sometimes called “GO bonds," and Revenue bonds.  GO bonds are unsecured and have maturities of ten or more years.  Revenue bonds are secured bonds, but they are higher risk than GO bonds, because if the revenue does not end up being as high as estimated, the government can default on these bonds.

Municipal bonds are something of a middle-ground in the bond market. They generally yield more than Federal bonds, but they have a higher chance of default, particularly in the case of revenue bonds. Municipal bonds also have the advantage of not being subject to Federal income tax on the interest.

Federal Bonds

Federal bonds are said to be “the most secure investments in the world,” because they are backed by the U.S. government.  The maturities of these bonds can range anywhere between one to ten years, and can be issued anywhere from $1,000 to above $1 million. 

There are three types of federal bonds: Treasury Bills (“T-bills”), Treasury Notes, and Treasury Bonds, which generally denote the differing amount of time you are loaning the money to the government. T-Bills tend to be the shortest and Treasury Bonds, the longest.

Ultimately Federal bonds are the safest option, but generally offer the least return. The income from these bonds is also taxable, unlike Municipal bonds.

The Risk Spectrum

Each of these three types of bonds presents a spectrum of risk, which of course comes with a spectrum of reward. If you're looking for something that's just a bit less risky than a stock, then a corporate bond may be for you. If you're looking for something nearly as safe as a savings account, but that ties your money up for longer, then you may be looking for a Federal bond.

Of course these bonds don't have to be held until their maturity, and in a future post we'll look at the bond market and how that affects the risk of owning these bonds.