A comparison of maturity term, coupon rate, risk rating and tax treatment of bonds issued by the U.S. Government, its agencies and corporate.
We explained bond fundamentals in our blog “How a Bond Works.” Here we compare the different bond types. U.S. Government bonds are issued by the Treasury, States or Agencies. They are high-grade bonds that carry a better rating than corporate bonds. When modeling asset allocation, the short-term T-Bills are often used as a proxy for cash or Money Market accounts. The longer the term of the bond the higher the coupon rate, when the Yield Curve is normal.
Treasury bonds are subject to Federal taxes but excluded from all State taxes. Munis are excluded from Federal and State taxes of the bond issuing State. MBS (Mortgage Backed Securities) offered by housing Agencies are fully taxable; their rates, therefore, are a bit higher.
TIPS (Treasury Inflation-Protected Security) is a special kind of bond in which the Face Value is continuously adjusted for inflation and denoted as Accrued Principal. The fixed coupon rate is applied on the Accrued Principal resulting in inflation-adjusted coupon payments. Hence, coupon rate is in real terms for TIPS and nominal terms for other securities (real rate plus inflation equals nominal rate). TIPS pay back the Accrued Principal at maturity. We show how to construct a bond ladder for generating income in real terms in our blog “Bond Ladder Using TIPS.”
Corporate bonds are also fully taxable. Investment grade bonds are BBB or better rated and are offered by companies with strong balance sheet. High-Yield or Junk bonds are BBB or lower rated and given their higher risk of default, they also offer higher rates. The ratings specify the level of risk, which then dictates the expected rate of return.
Callable bonds are redeemable by the issuing company after a certain time period by paying the principal face amount back to the investor. They usually offer a slightly higher coupon rate to afford this flexibility. The company may call back the bond if the interest rate moves lower so that they can reissue a new bond at a lower coupon rate.
The performance of bonds is compared to other asset classes such as stocks, commodities and real estate in our blog “Asset Classes 30-Year Performance History.”
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