Key Takeaways
- Treasury securities are backed by the full faith and credit of the U.S. government — considered risk-free for default
- Treasury interest is federally taxable but EXEMPT from state and local taxes
- Municipal bonds offer interest that is EXEMPT from federal taxes (and often state taxes for residents)
- Tax-equivalent yield = Municipal Yield ÷ (1 - Tax Rate) — used to compare muni bonds to taxable bonds
- Corporate bonds rated BBB/Baa and above are 'investment grade'; below that are 'high-yield' (junk) bonds
Types of Bonds
Understanding the different types of bonds, their issuers, and tax implications is essential for making appropriate investment recommendations.
U.S. Treasury Securities
Treasury securities are issued by the U.S. Department of the Treasury and are considered the safest investments because they're backed by the full faith and credit of the U.S. government.
Types of Treasury Securities
| Type | Maturities | Interest | Key Features |
|---|---|---|---|
| T-Bills | 4 weeks to 1 year | Sold at discount | No periodic interest |
| T-Notes | 2 to 10 years | Semiannual | Medium-term |
| T-Bonds | 20 to 30 years | Semiannual | Long-term |
| TIPS | 5, 10, 30 years | Semiannual (adjusted) | Principal adjusts with inflation |
| I-Bonds | Up to 30 years | Compound semiannually | Inflation protection, savings bonds |
Treasury Tax Treatment
| Tax Type | Treatment |
|---|---|
| Federal | Taxable |
| State/Local | EXEMPT |
Memory Tip: Treasury interest is EXEMPT from state taxes because the federal government doesn't allow states to tax it (supremacy clause).
Agency Securities
Agency securities are issued by government-sponsored enterprises (GSEs) to fund specific sectors like housing.
| Issuer | Full Name | Backed by Government? |
|---|---|---|
| GNMA (Ginnie Mae) | Government National Mortgage Association | Yes (full faith and credit) |
| FNMA (Fannie Mae) | Federal National Mortgage Association | Implicit guarantee only |
| FHLMC (Freddie Mac) | Federal Home Loan Mortgage Corporation | Implicit guarantee only |
Key Points
- GNMA is the only agency explicitly backed by the U.S. government
- Agency bonds have slightly higher yields than Treasuries due to credit risk
- Most agency securities are mortgage-backed securities (MBS)
Municipal Bonds
Municipal bonds (munis) are issued by state and local governments and their agencies.
Types of Municipal Bonds
| Type | Backing | Risk Level |
|---|---|---|
| General Obligation (GO) | Full taxing power of issuer | Generally lower |
| Revenue Bonds | Specific project revenue (tolls, fees) | Varies by project |
Municipal Bond Tax Treatment
| Tax Type | Treatment |
|---|---|
| Federal | EXEMPT |
| State/Local | Usually exempt for residents of issuing state |
Triple Tax-Free: Bonds may be exempt from federal, state, and local taxes if you live in the issuing state.
Tax-Equivalent Yield
To compare a tax-free municipal bond to a taxable bond:
Tax-Equivalent Yield = Municipal Yield ÷ (1 - Marginal Tax Rate)
Example: An investor in the 32% tax bracket considers a muni yielding 4%.
Tax-Equivalent Yield = 4% ÷ (1 - 0.32) = 4% ÷ 0.68 = 5.88%
The investor would need a taxable bond yielding at least 5.88% to match the after-tax return of the 4% muni.
Who Benefits Most from Municipal Bonds?
Investors in higher tax brackets benefit most because the tax exemption is more valuable.
Corporate Bonds
Corporate bonds are issued by companies to raise capital. They offer higher yields than government bonds but carry more credit risk.
Credit Ratings
| Rating (S&P/Moody's) | Category | Description |
|---|---|---|
| AAA/Aaa | Investment Grade | Highest quality |
| AA/Aa | Investment Grade | High quality |
| A/A | Investment Grade | Upper-medium quality |
| BBB/Baa | Investment Grade | Medium quality (lowest IG) |
| BB/Ba | High Yield | Speculative |
| B/B | High Yield | Highly speculative |
| CCC/Caa and below | High Yield | Very high risk |
Investment Grade vs. High Yield
| Category | Ratings | Characteristics |
|---|---|---|
| Investment Grade | BBB/Baa and above | Lower risk, lower yields, suitable for conservative investors |
| High Yield (Junk) | BB/Ba and below | Higher risk, higher yields, speculative |
Zero-Coupon Bonds
Zero-coupon bonds pay no periodic interest but are sold at a deep discount to par.
| Feature | Details |
|---|---|
| Interest | None during life of bond |
| Purchase Price | Deep discount |
| Maturity Value | Par (face value) |
| Taxes | Annual phantom income (imputed interest) |
| Reinvestment Risk | None |
Example: Buy a 10-year zero-coupon bond for $500, receive $1,000 at maturity.
Exam Tip: Know the tax treatment for each bond type. Treasury = state/local exempt. Municipal = federal exempt. Use the tax-equivalent yield formula to compare munis to taxable bonds.
An investor in the 30% tax bracket is considering a municipal bond yielding 4%. What is the tax-equivalent yield?
Which of the following is TRUE about Treasury securities?
A corporate bond rated BB would be classified as:
Which government agency's securities are backed by the full faith and credit of the U.S. government?
2.4 Bond Risks and Duration
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