U.S. Treasuries are considered among the safest investments because they are backed by the "full faith and credit" of the U.S. government. They come in three versions: Treasury bills, which mature in 90 days to one year; Treasury notes, which mature in two to ten years; and Treasury bonds, which have maturities of up to 30 years. While the regular interest payments from Treasuries are considered quite secure, the value of these bonds can fall sharply when interest rates rise. The bonds also carry inflation risk: You could lose money in inflation-adjusted terms if, say, consumer-price increases outpace the interest rate on your bonds. Worried about that risk? You might talk to a financial professional about inflation-indexed Treasury bonds.
Corporate securities can offer higher yields, but they are also among the riskiest bonds, because they are backed only by a company's promise to pay. Interest on corporate bonds is fully taxable. Corporate bonds are generally categorized into two broad groups: investment grade and high-yield. Investment-grade bonds have ratings of Baa and above from Moody's Investors Service and BBB and above from Standard & Poor's. High-yield bonds are considered to have a greater risk of default than their investment-grade counterparts. Indeed, they are often called "junk bonds."
Municipal bonds, or "munis," generally have lower yields than other bonds. But they are still a popular investment, especially with high-income earners, for a compelling reason: They pay interest that is potentially exempt from federal, state and local income taxes. Typically, munis are exempt from state taxes if you own securities issued from within your state of residence, while the local tax exemption applies if you hold securities issued from within your city of residence. Munis can be broadly classified into two groups: general obligation and revenue bonds. General obligation bonds are backed by the taxing authority of the state or municipality. Meanwhile, revenue bonds are issued by an agency, commission or authority to pay for things like airport construction, a new bridge, highways or college dorms. Fees, taxes or tolls from these projects are used to pay off the debt. Keep in mind that municipal-bond interest can be subject to the Alternative Minimum Tax. To learn more about munis, click here to learn more about municipal bonds.
Mortgage securities are backed by an underlying bundle of mortgages. After a bank or mortgage company makes a home loan, it sells that loan to an investment bank or a quasi-governmental agency such as Fannie Mae or Freddie Mac. The bank or agency bundles these mortgages into securities that are sold to investors, who then receive payments based on the combined interest rate of the loans. While these securities can provide an income stream, they also carry a number of risks. For instance, if borrowers prepay their mortgages or refinance to take advantage of lower rates, mortgage-bond investors receive their initial investment back sooner than expected. Because homeowners generally refinance when interest rates are low, investors will have to reinvest at those lower rates. This is known as prepayment risk. Investors also face other risks, notably the risk that some homeowners may default on their mortgage payments. This can translate into a loss of money for mortgage-bond holders.
International bonds, including emerging-market debt, are issued by non-U.S. governments and corporations. As with U.S. bonds, investors in international bonds have to rely on issuers to have the financial strength to meet their periodic interest payments and repay the principal at maturity. International bonds carry many of the same risks as U.S. bonds, including interest rate risk, inflation risk and default risk. In addition, investors have to contend with another important risk: currency risk. If, for example, foreign currencies fall in value against the dollar, your interest payments will be worth less when converted into dollars. Conversely, if foreign currencies strengthen, your payments could increase. International bonds can also be buffeted by political, economic and social turmoil in the issuing country.