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Bond Investing: Three Major Types of Bonds

written by: Tim Plaehn•edited by: Jason C. Chavis•updated: 10/26/2010

Investors interest in bond should first understand the different types of bonds. The three classes of bonds provide a wide range of income and investment safety options. So, what are three types of bonds that will help investors?

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    Bonds Defined

    Before learning what are three types of bonds for investors, a little background on this type of investment needs to be understood. Bonds are debt securities issued by governments and corporations. They are how these entities borrow money and the resulting bonds are marketable securities that investors can buy, sell or trade. A typical bond will have a face amount, coupon rate or rate of annual interest payment and a maturity date. A bond holder will receive the interest amount in semi-annual payments and the face amount will be repaid when the bond matures.

    As marketable securities, bond prices will fluctuate based on the coupon rate of the bond in relation to current interest rates and the credit rating of the bond issuer. Bonds can trade at a premium or discount to the face amount, based on these factors. As a general rule, rising interest rates will cause bond market prices to fall and falling rates will cause bond prices to rise.

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    Government Bonds

    Government bonds are debt securities issued by the federal government and some of its agencies. U.S. government bonds are issued by the Treasury Department and often referred to as Treasuries. The Treasury issues three types of debt securities: Treasury bills have a maturity of one year or less, Treasury notes have maturities of 2 to 10 years and Treasury bonds have maturities of 30 years at issue.

    Treasury securities are considered to be the safest class of investment securities. The large secondary market for Treasuries also makes it easy to buy and sell Treasury bills, notes and bonds. The best known government agency bonds are mortgage backed securities issued by Ginnie Mae -- GNMA.

    Besides the usual paths of buying bonds through a broker or in a mutual fund or ETF, Treasury securities can be purchased directly from the U.S. Treasury at the TreasuryDirect website.

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    Municipal Bonds

    Municipal bonds are sold by state and local governments to fund their operations and government construction projects. The big appeal of municipal bonds is that the interest they pay is tax free to investors. Municipal bond issuers will have credit ratings that indicate the potential for an investor to receive the interest and principal payments promised by the bond issue.

    Individual municipal bonds can be purchased through a bond dealer or broker. Municipal bond mutual funds and unit investment trusts provide investment access to diversified portfolios of municipal bonds. Funds provide the benefits of professionally managed portfolios and monthly dividends of tax free income.

    Municipal bond interest is exempt from federal income tax. If an investor buys muni bonds issued in his home state, the interest earned will also be exempt from state income taxes. Investors in high income tax states can earn double tax exempt interest by buying local bonds or municipal bond funds that hold municipal bonds from a single state.

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    Corporate Bonds

    Corporations issue bonds as a way of borrowing money to fund a corporation's operations and growth. Corporate bonds will pay a higher rate of interest than the super safe Treasury securities. Investors can choose their level of safety and income by looking at the credit rating of the issuing corporation. Credit ratings of BBB up to AAA are considered to be investment grade. Bonds from issuers with credit ratings below BBB are non-investment grade. These lower rated bonds are also referred to by the terms high-yield or junk bonds.

    HIgh yield bonds and high yield bond funds can provide excellent returns to investors in an improving economy. When times get better, corporations will have their credit rating upgraded, increasing the value of their bonds and providing capital gains as well as high income to investors. An economic slow down or recession can result in negative returns for high yield bond investors.

    Investment grade bonds will provide higher income than government bonds and can be a good investment in times of a slowing economy or during periods of deflation. This makes understanding what are three types of bonds such an important piece to the financial puzzle.

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    Investing in Bonds: Types of Bonds: