For bond investors looking for low risk investments, U.S. Treasuries are typically the best bet, as they are backed by the full faith and credit of the U.S. government. The U.S. Treasury regularly offers three types of securities: Treasury bills, notes, and bonds. Treasury bills (or T-bills) are short-term securities that mature in one year or less from their issue date and are purchased for a price less than their face value. Treasury notes and bonds are securities that pay a fixed rate of interest every six months until the security matures. Treasury notes mature in more than a year, but not more than ten years from their issue date. Bonds, on the other hand, mature in more than ten years from their issue date. Bonds and notes can usually be purchased for a price close to their face value. Interest from Treasury securities is exempt from state and local income taxes, which make them particularly beneficial if you live in a state with a high tax rate.
In addition to U.S. Treasuries, certain federal government agencies or government-sponsored enterprises (GSEs) have been authorized by Congress to issue debt securities to certain groups of borrowers, such as homeowners, farmers, and students. In general, debt securities issued by GSEs are considered to have high credit quality. However, it is important to recognize that issuers in the U.S. Agency market are corporations and that their bonds are not explicitly guaranteed by the U.S. Government.
Just as the federal government needs funds to operate, local governments and public entities, such as school districts, often issue municipal bonds to meet their financial needs. Municipal bonds can be issued by states, cities, towns, or public commissions to provide money for schools, hospitals, and other public works. These securities provide income that is free of federal and, in some cases, state and local taxes. (Although income generated by most municipal bonds is exempt from taxes, any capital gains earned from the sale of bonds are subject to all federal and most state tax laws and certain bonds may be subject to the alternative minimum tax.)
Corporate bonds, unlike U.S. Treasuries and municipal bonds, are fully taxable and may carry greater risk. At the same time, they may offer higher returns than tax-advantaged bonds. Corporate bonds are issued by corporations in the need of capital and are typically issued in denominations of $1,000 with terms of 1 to 30 years. Unlike stocks, bonds do not give the holder ownership interest in the corporation, as they are simply a tool used to lend the corporation funds they need to meet their goals.
Because corporate bonds generally carry greater risks than government and municipal bonds, it is critical that investors understand the quality of the bond they are considering for investment. To evaluate the credit quality of a bond, investors can look to organizations that rate various corporate bonds, such as Moody's Investors Service and Standard & Poor's. Those bonds rated Baa or above by Moody's and BBB or above by Standard & Poor's are considered investment-grade. Bonds rated below investment grade are considered more speculative and carry greater risk.