Most people hear the word “bonds” and picture one broad category: relatively safe investments that pay regular interest. In practice, the bond market contains securities issued by very different kinds of borrowers, with different risks, tax treatment, and market characteristics.
One of the first questions to ask is who issued the bond. Lending to the U.S. government is different from lending to a corporation, a city, or a developing-country government because each borrower relies on different financial resources and operates under a different framework for repaying its debt.
Grouping bonds by issuer therefore gives you a useful map of the market. It does not tell you everything about a particular bond, but it is a good place to begin.
Government Bonds: The Bedrock of Global Finance
Government bonds are issued by national governments to finance spending and refinance existing debt. In the United States, the main federal government securities are U.S. Treasuries, which are backed by the full faith and credit of the U.S. government.
Treasuries occupy a special place in global finance. Their yields are widely used as a risk-free benchmark for valuing other financial assets, and the U.S. Treasury market is the deepest and most liquid government securities market in the world.
Treasury securities come in several forms. Treasury bills mature in one year or less, while Treasury notes and Treasury bonds cover longer maturities. Treasury Inflation-Protected Securities (TIPS) adjust their principal for inflation. The mechanics of each type differ, but they all represent borrowing by the U.S. federal government.
U.S. savings bonds are another form of federal government debt, but they work differently from marketable Treasury securities. Series EE and Series I savings bonds are registered to individual owners and cannot be bought or sold in the secondary market. Series I Bonds combine a fixed rate with an inflation-based rate, making them a retail-oriented way to hold U.S. government debt with built-in inflation adjustment.
Government bonds are not limited to the United States. The United Kingdom issues gilts, Germany issues Bunds, and Japan issues Japanese Government Bonds (JGBs). Each reflects the creditworthiness, monetary system, and financial conditions of its own issuer.
The differences among government borrowers can become extreme. In February 2012, amid Greece’s sovereign-debt crisis and restructuring, the yield on its 10-year government bonds averaged about 29%, while the 10-year U.S. Treasury yield averaged roughly 2%. Both were government bonds, but the enormous yield gap reflected very different perceptions of repayment risk.
Sovereign bonds from emerging-market countries can carry substantially more risk. Investors may need to consider the government’s finances, political and legal stability, and—in some cases—currency risk. A bond issued in the government’s own currency can behave differently from debt issued in U.S. dollars or another foreign currency.
That range is why government bond should not be treated as a synonym for low risk. U.S. Treasuries sit at one end of the sovereign-bond spectrum, while other government borrowers can present very different combinations of credit, currency, and market risk.
Agency and GSE Bonds: Government-Linked, but Not Treasuries
Another part of the bond market consists of securities issued by federal agencies and government-sponsored enterprises (GSEs). These securities are separate from U.S. Treasuries and often help finance specific areas of the economy, such as housing and agriculture.
The important distinction is the government backing. Securities issued or guaranteed by a federal agency can carry the full faith and credit of the U.S. government, while obligations of GSEs generally do not. The label agency or government-sponsored therefore should not be treated as equivalent to Treasury; the specific issuer and guarantee matter.
Corporate Bonds: Lending to Businesses
Corporate bonds are issued by companies that want to raise capital without issuing additional ownership shares. Investors provide the money, and the company promises to make the bond’s scheduled interest and principal payments.
Unlike U.S. Treasuries, corporate bonds expose investors to company-specific credit risk. A business can suffer falling profits, take on too much debt, or ultimately become unable to meet its obligations. Investors generally demand additional yield for taking that risk, which is one reason corporate bonds commonly yield more than comparable Treasuries.
The difference between a corporate bond’s yield and the yield on a comparable Treasury is often called its credit spread. A wider spread generally signals that investors are demanding more compensation for the risks associated with the corporate issuer.
Corporate bonds are commonly divided into two broad groups based on credit ratings:
- Investment-grade bonds are rated BBB−/Baa3 or higher by the major rating agencies. They are generally viewed as having lower credit risk than bonds rated below investment grade.
- High-yield bonds, sometimes called junk bonds or speculative-grade bonds, fall below the investment-grade threshold. They generally offer higher yields because investors require more compensation for greater estimated default risk.
Credit ratings provide a useful starting point, but they are not guarantees. The financial condition of the issuer can change, ratings can be upgraded or downgraded, and two bonds carrying the same broad rating can still have different levels of risk.
Municipal Bonds: Public Financing and Tax Advantages
Municipal bonds, commonly called munis, are issued by states, cities, counties, school districts, public authorities, and other governmental entities. They are used to finance public needs such as schools, roads, water systems, hospitals, transit projects, and other infrastructure.
The source of repayment can differ from one municipal bond to another. General obligation bonds are generally supported by the finances and taxing resources of the government issuer, while revenue bonds depend on specified sources of revenue, such as tolls, utility payments, or income from a particular project.
One of the most distinctive features of municipal bonds is their tax treatment. Interest on many munis is exempt from federal income tax, and some bonds may also receive state or local tax advantages depending on where the investor lives and where the bond was issued.
That tax advantage can make a lower stated yield more competitive with a taxable bond. Suppose a tax-exempt municipal bond yields 3.5% and an investor faces a 37% federal marginal tax rate. A simplified tax-equivalent-yield calculation is:
Tax-Equivalent Yield = Tax-Exempt Yield ÷ (1 − Marginal Tax Rate)
3.5% ÷ (1 − 37%) ≈ 5.6%
In that simplified comparison, the 3.5% tax-exempt municipal yield provides roughly the same after-federal-tax income as a 5.6% taxable yield. State taxes and, for some municipal bonds, alternative minimum tax treatment can change the comparison.
Municipal bonds can still carry credit, interest-rate, liquidity, and other risks.
A Practical Comparison
| Bond Family | Issuer | Main Risk to Notice | Tax Treatment | What Makes It Distinctive |
|---|---|---|---|---|
| U.S. Treasuries | U.S. federal government | Interest-rate and inflation risk; very low credit risk | Federally taxable; exempt from state and local income taxes | Widely used as a benchmark and supported by a deep, liquid market |
| Agency/GSE Bonds | Federal agencies and government-sponsored enterprises | Credit and liquidity risk vary by issuer; government backing differs | Varies by issuer and security | Government-linked debt; backing is not always equivalent to U.S. Treasury debt |
| Investment-Grade Corporate | Companies with investment-grade credit ratings | Corporate credit risk plus interest-rate and liquidity risk | Generally taxable | Additional yield relative to Treasuries in exchange for taking corporate credit risk |
| High-Yield Corporate | Companies rated below investment grade | Higher default and liquidity risk | Generally taxable | Higher potential income accompanied by substantially greater credit risk |
| Municipal | States, cities, counties, authorities, and other public issuers | Credit, interest-rate, and liquidity risk; repayment source varies | Interest on many issues is federally tax-exempt; state and local treatment varies | Potential tax advantages distinguish them from most taxable bonds |
| TIPS | U.S. federal government | Interest-rate risk; market value can fluctuate | Federally taxable; exempt from state and local income taxes | Principal adjusts with inflation |
| Foreign Sovereign Bonds | National governments outside the United States | Sovereign credit risk and, depending on the bond, currency risk | Depends on the security and investor jurisdiction | Risk can vary enormously across countries and currencies |
What Changes When You Choose a Different Bond Type
There is no single bond type that is best in every situation. Different bond types come with different combinations of risks and features.
Credit risk changes with the borrower. U.S. Treasuries carry very different credit risk from corporate bonds, municipal bonds, or debt issued by less financially secure governments. Within corporate and municipal markets, credit quality can also vary substantially.
Tax treatment can change the income an investor actually keeps. That is why a tax-exempt municipal yield and a taxable corporate yield should not always be compared at face value.
Inflation exposure can differ as well. Conventional fixed-rate bonds promise payments in nominal dollars, while TIPS and Series I savings bonds incorporate mechanisms designed to respond to inflation.
Currency risk becomes important with some foreign government bonds. A bond’s return in its home currency can differ from the return experienced by an investor measuring wealth in U.S. dollars.
Liquidity also varies. U.S. Treasuries trade in an exceptionally deep market, while some corporate, municipal, and foreign bonds may be harder or more costly to trade.
The useful question, then, is not simply “Which bond has the highest yield?” It is “What am I being compensated for by that yield?” The answer may involve credit risk, tax treatment, inflation exposure, currency risk, liquidity—or several of them at once.
Sources and Further Reading
Selected authoritative sources used to verify the definitions, examples, and tax treatment discussed in this article:
• Bank of Greece — Greek government securities (2012 benchmark bond yields)
• Federal Reserve Bank of St. Louis (FRED) — 10-Year Treasury Constant Maturity Rate
• TreasuryDirect — Treasury Marketable Securities and Savings Bonds
• FINRA — Bonds, Corporate and Agency Bonds, and High-Yield Bonds