Choosing a Bond

Bonds as an overall investment category contain something for almost everyone. In this section, we offer a list of the bonds available and a summary of their features.

Municipal bonds. Municipal bonds are bonds that are issued by state and local governments. The interest earned on municipal bonds is not subject to federal income tax. In addition, if you're a resident of the state or locality that issues the bonds, the interest is generally not subject to state and local income tax. Because of this attractive tax feature, municipal bonds often pay interest at rates lower than other types of bonds. However, if you are in a certain tax bracket, your tax savings may offset the lower interest rate paid by municipal bonds.

Warning As with other investment vehicles, such as buying a home, you should never invest in a certain type of bond for tax advantages alone. It's important that you take into consideration the amount of interest you could be earning on a similar investment without the tax advantages and then compare that to your tax savings.

Zero coupon bonds. Zero coupon bonds are bonds that are sold at a discount, and when they mature, the owner receives the full face value of the bond. Unlike most other bonds, zero coupon bonds do not make periodic interest payments. The disadvantage of zero coupon bonds is that you can be locked into this investment at a lower than market interest rate. Another downside to investing in zero coupon bonds is that even though you don't actually receive any periodic interest payments, you are taxed on the payments you're earning. So not only do you not have use of your interest earned, but you're taxed on it as well.

Treasuries. You can invest in the U.S. government by buying U.S. Treasury bills, bonds or notes. The biggest advantage of investing in treasuries is that there's practically no risk involved. Another advantage that treasuries have is that the interest you receive is not taxed at the state or local level. This may help to offset the disadvantage of treasuries, namely that their interest rates are on the lower end of the scale.

Treasury Inflation-Protected Securities (TIPS). TIPS are marketable securities whose principal is adjusted by changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of 5, 10, and 30 years.

Savings bonds. Savings bonds (Series EE and Series I) are a type of treasury issued by the federal government. Like other treasuries, savings bonds have the advantage of safety and low risk on their side, as well as the deferred tax benefits available for the interest earned. However, because they are a low risk investment, the interest rates they pay aren't very high.

There are special tax rules for savings bonds proceeds used to pay for college tuition and fees. If you're investing in these savings bonds to pay for educational costs, you could end up not having to pay tax on part or all of the interest the bonds have earned.

Corporate bonds. When you invest in corporate bonds, you are lending money to a company and in return you receive a specific interest rate for a specific period of time. The interest rate you receive from investing in corporate bonds and the risk you assume depend on the credit history of the corporation issuing the bond, the duration of the bond and whether it is convertible into stock.

Junk bonds. Junk bonds are bonds issued by corporations and considered high-risk because of their credit rating. To offset the risk involved, these bonds offer higher interest rates than other corporate bonds.