The Bond market is a largely misunderstood piece of the financial markets puzzle, so here we will cover some of the basics for those looking to invest in this area. When looking for the safest investments in bonds, US treasuries will be viewed as the clearest choice. The reason for this comes from the fact that all interest and principal payments will be guaranteed with the “full faith and credit” that has been established by the US government.
Interest payments from bond investments are exempt from both state and local tax liabilities; however, federal tax obligations will still apply when dealing with these investments. Given that these bond investments are essentially free from default risks, US treasuries pay out some of the lowest yields (interest payments) in the world.
What Is a Treasury Bond?
Treasury bonds are savings bonds; they are fixed-interest debt securities issued by the U.S. government that are guaranteed to be paid out plus interest. All treasury bonds, though issued under the same institution, are not the same. Here we will look at three of the main types of treasury bonds available:
- Treasury Bills – Also referred to as “T-bills,” treasury bills have the shortest maturity dates (time to expiration). Generally, these maturities come at 13 weeks, 26 weeks, or one year. These bills can be purchased at a discount to the face value of $10,000 but can still be redeemed for the full $10,000 face value at the time of maturity. The difference between the purchase price and the $10,000 payment received at maturity is reflective of the total amount of interest earned.
- Treasury Notes – Treasury notes have maturity dates of between two and 10 years. The interest for these notes is paid twice each year, at an unchanging rate. Minimum investments (original purchase amounts) are seen at $1,000 or $5,000, and this will change depending on the maturity date.
- Treasury Bonds – Treasury bonds mature after 10 years, which is the longest maturity date in these categories. Similar to Treasury notes, Treasury bonds pay interest twice each year, and are sold in $1,000 denominations.
Alternatives to Treasury Bonds: Higher Yield Bonds
There are other bond options outside the Treasury as well. Here we outline the main two:
- Mortgage-Backed Securities – Mortgage-Backed Securities show ownership stakes in packaged mortgage loans. These are issued or guaranteed by the government, through agencies including Ginnie Mae, Freddie Mac, or Fannie Mae. Tax obligations will apply to interest, which is paid each month. Mortgage-backed securities will typically yield 2% to 4% more than bonds with similar maturities. This market has been subject to many changes since the 2007 housing crisis but is still in operation.
- Corporate Bonds – Corporate Bonds are bonds issued by private companies and corporations are basically an “IOU” on the part of the corporation. Payouts from Corporate Bonds are taxable, and these bonds are typically denominated in amounts of $1,000 or more. Maturity terms are generally from 1 to 20 years but can be extended much further. The value of these bonds will depend on the credit rating, and because of this there are higher risk levels associated with these investments. At the same time, however, this creates the potential for higher yields.
- Junk Bonds – This is a more colloquial term used for bonds issued by companies considered to be on the younger and riskier side, such as an unstable startup; if they default, they will not be able to guarantee repayment of the bond. These bonds offer higher yields but are coupled with a higher risk of default, as signified by these companies’ lower credit ratings.
Picking the Best Bonds for You
With all of these types of bonds available, investors will need to assess their risk tolerance levels before investing. More conservative investments are generally the bonds guaranteed by the U.S. government. Higher yields, however, can be achieved with corporate bonds. As with any investment strategy, those looking to select bonds should diversify between both types of bonds and other asset classes.
To learn about bond funds, a type of mutual fund that diversifies between many of the types of bonds discussed above, please read NerdWallet’s introduction to mutual funds.