Smart Money2

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.

The bonds issued by Uncle Sam are called Treasurys. They’re grouped in three categories.

U.S. Treasury bills: maturities from 90 days to one year
U.S. Treasury notes: maturities of more than one year to 10 years
U.S. Treasury bonds: maturities of more than 10 years

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 10-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.

Compared with other types of bonds, however, even that 10-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
Municipal bonds are a small step up on the risk scale from Treasurys, but they make up for it in tax benefits. Thanks to federal law, the federal government can’t tax interest on most state or local bonds (and vice versa). Better yet, a local government will often exempt its own citizens from taxes on its bonds, such that many municipal bonds are safe from city, state and federal taxes. (A happy state of affairs 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 (or after-tax return) may be higher than it would be with a regular bond.

Corporate Bonds
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 stiff competition or management missteps. Take, for example, Enron and WorldCom.

That said, corporate bonds can also be the most lucrative fixed-income investment, since you’re 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:

Short term: one to five years
Intermediate term: five to 12 years
Long term: longer than 12 years

The credit quality of companies and governments is closely monitored by three major debt-rating agencies: Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. 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 the 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 sell bonds to raise money. 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
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. These bonds can be issued by the government, a municipality or a corporation.

Zeros are usually priced aggressively and are useful for investors 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. They can, for example, be a handy tool for those approaching retirement.

Zeros do have a tax drawback, however. Since interest is technically earned and compounded semiannually, holders of zeros are obliged to pay taxes each year on the interest as it accrues. This means you have to pay the tax before you get the money, which might be a struggle for some investors.

This can be avoided by holding the bond in a tax-advantaged account, such as an IRA. Zero-coupon bonds issued by a municipality will also be federally (and in some cases state and locally) tax free, although like their traditional muni brethren, they’ll offer lower coupon rates than a taxable bond.