A bond is a debt security, similar to an IOU. The borrower issuing the bond is looking to raise money for a certain amount of time. When you buy a bond, you’re lending to the issuer, which may be a government, municipality, or corporation. In return, you receive a specified rate of interest for the life of the bond.
Buying bonds requires more knowledge and research than other saving methods, such as money market and savings accounts. The credit worthiness of the borrower is important, because it indicates the likelihood of the loan being repaid. The length of the loan, the interest rate offered, and the price of the bond are also key considerations. Bonds, like stocks, can be traded between investors in the secondary market after initial issuance. Here are some of the most common types of bonds.
Treasury bonds are issued by the U.S. government with a maturity of more than 10 years. The interest you receive is taxable at the federal level, but exempt from state and local taxes.
Issued by the U.S. government, the most popular savings bonds are EE and I bonds. EE bonds pay a fixed rate of interest for up to 30 years. I bonds rates fluctuate with the rate of inflation. Here too the interest you earn is taxable only at the federal level.
Issued by a government agency or a government-sponsored enterprise (GSE), these bonds are not fully guaranteed in the same way as U.S. Treasury bonds, but they still offer a high level of safety.
Issued by a state, city, county, or other public entity to fund the construction of schools, hospitals, highways, sewers, universities, and other projects. Generally, the interest on municipal bonds is exempt from federal income tax. If you live in the state where the bond is issued, you may also avoid state and local taxes on the interest you earn.
Fully taxable, these bonds are issued by corporations to fund capital improvements, expansions, debt refinancing, or acquisitions. The credit-worthiness of these bonds is directly linked to the stability of the issuer and can vary from investment-grade to junk.
Also called junk bonds, high yield bonds come with a higher risk of default. As compensation, you’ll receive a higher rate of return—the higher the yield, the greater the risk.
By investing in a variety of individual bonds, bond mutual funds provide diversification and professional management. They also expose you to daily fluctuations in value, which, for many investors, undercuts the stability they seek by adding bonds to their portfolios.