Choosing the Right Bond Type

Any financial planner will tell you that you should hold a certain percentage of bonds in your investment portfolio as a hedge against risk or to create a source of regular income. But not all bonds work in exactly the same way, and some are better for certain purposes than others. That’s why it’s important not just to own bonds, but to own the right bonds. Whatever your goals—diversification, retirement income, tax efficiency, or all of the above—here’s what you need to know about U.S. Treasuries, municipal bonds, and corporate bonds.

What Differentiates Major Bond Types

All bonds are a form of debt. When you buy a bond, you are lending money to that particular issuer. In return, the issuer promises to return your principal, or original investment, at some point in the future and to pay interest on the money in the meantime.

Treasuries, municipal bonds, and corporate bonds differ in several important ways. These differences influence the interest investors expect to earn and the risk they are willing to take on.

They vary based on:

• Who issues the bond, and how financially stable that issuer is
• How interest income is taxed
• How much credit and interest-rate risk the bond carries

In general, safer issuers can borrow at lower interest rates, while riskier issuers must offer higher yields to attract investors.

Taxes also play a role. Taxable bonds may need to pay higher interest than tax-advantaged bonds. Likewise, bonds with greater credit risk or greater interest-rate sensitivity typically offer higher yields.

Credit risk is the possibility that the issuer may default or fail to make promised payments.

Interest-rate risk reflects how changes in market interest rates affect a bond’s value. When rates rise, existing bonds with lower yields become less attractive—especially if they need to be sold before maturity. Longer-term bonds generally face more interest-rate risk because investors are locked into a fixed rate for longer.

In short, every bond involves trade-offs. The sections below compare how the three major bond types stack up across these key dimensions.

U.S. Treasury Securities

Treasury securities are issued by the United States government and backed by its “full faith and credit.” As such, they have long been considered the gold standard of safety, not only for Americans but also for investors worldwide.

These securities come in five types: Treasury bonds, bills, and notes, plus Treasury inflation-protected securities (TIPS) and floating-rate notes (FRNs).

The first three differ primarily in their terms. Treasury bonds are available with terms of either 20 or 30 years. Treasury notes have shorter terms: 2, 3, 5, 7, or 10 years. Treasury bills have even shorter terms, from 4 to 52 weeks.

TIPS differ from the other three in that their principal and interest payments will adjust periodically with inflation. They come in terms of five, 10, or 30 years. FRNs are similar but have terms of two years.

Generally speaking, the longer the term of a Treasury security, the higher the interest rate it will pay, except in rare circumstances referred to as an inverted yield curve.

Key Characteristics of Treasuries

• Minimal credit risk because of the federal government’s backing
• Typically pay lower yields than riskier bonds, such as corporate issues
• Can be purchased directly from the government or through banks and brokers
• Interest is taxable at the federal level but exempt from state and local income taxes

Municipal Bonds

Municipal bonds are issued by state, county, and local governments, often to finance specific public works projects, such as a new school or highway. They are not backed by the federal government and can vary in risk depending on the issuer’s creditworthiness. Some bond rating agencies, such as Moody’s and S&P Global, issue ratings for these bonds.

Most municipal bonds have terms ranging from one to 30 years and typically pay fixed interest rates. Individual bonds purchased through a broker often require a minimum investment of about $5,000. Investors can also gain exposure through mutual funds or exchange-traded funds (ETFs).

Interest is generally exempt from federal income taxes and, in many cases, from state and local taxes as well—particularly if you live in the state where the bond is issued.

Because of these tax advantages, municipal bonds usually pay lower interest rates than comparable Treasury or corporate bonds. To compare the return on a municipal bond to a taxable one, you can calculate its tax-equivalent yield, which shows what a taxable bond would need to pay to deliver the same after-tax return.

Tax-equivalent yield = Municipal bond yield divided by (1 minus your tax rate).

For example, a municipal bond yielding 4% would be equivalent to about a 4.5% taxable yield for someone in the 12% tax bracket, or about 6% for someone in the 35% bracket. This calculation doesn’t account for potential state tax savings.

In general, the higher your tax bracket, the more attractive municipal bonds may be.

Key Characteristics of Municipal Bonds

• Interest is often exempt from federal income tax
• May be exempt from state and local taxes for in-state investors
• Credit risk varies by issuer and project
• Rated by major bond-rating agencies
• Available through brokers, mutual funds, and ETFs

Corporate Bonds

The private sector also issues bonds for various purposes. As with municipal bonds, the creditworthiness of corporate bonds can vary widely.

Bond-rating agencies evaluate corporate bonds using different grading systems. For example, Moody’s divides long-term bonds into investment-grade and non-investment-grade categories. The highest investment-grade rating is Aaa, while the lowest is Baa3. Bonds rated below that threshold are considered non-investment-grade, also known as junk bonds.

Not surprisingly, the safer a corporate bond is judged to be, the lower the interest rate the issuer will need to pay to attract investor capital. Lower-rated bonds generally offer higher yields to compensate investors for taking on additional risk.

Corporate bonds, like Treasuries, are fully taxable on the federal level.

Key Characteristics of Corporate Bonds

• Issued by publicly traded and private companies to raise capital
• Typically offer higher yields than Treasuries and most municipal bonds
• Carry higher risk, which can vary widely by issuer
• Rated by major bond-rating agencies
• Sold through brokers and investment funds
• Interest income generally fully taxable

Comparing Treasuries, Munis, and Corporate Bonds

Here are the key points of comparison at a glance:

Credit Risk

• Treasuries: lowest default risk because of government backing
• Municipal bonds: generally low risk, depending on the issuer
• Corporate bonds: risk varies based on the issuer’s financial health

Tax Considerations

• Municipal bonds are often exempt from federal and, in some cases, state taxes.
• Tax-equivalent yield can help compare taxable and tax-free bonds.
• Municipal bonds tend to be most attractive to investors in higher tax brackets.

Income Stability and Volatility

• Treasuries generally provide the most stability.
• Longer-term bonds of any type may experience more price volatility before maturity.

How to Choose the Right Bond Type

All bonds have their pros and cons. The best option for you will depend on your risk tolerance, income needs, tax bracket, and time horizon. For example:

• Treasury securities involve the least risk but generally offer lower returns
• Lower-quality bonds may provide higher income with greater risk
• Municipal bonds may make sense for investors in higher tax brackets
• Bonds can be selected to mature at a specific time to align with future goals

You don’t have to limit yourself to one type of bond and can mix and match as needed.

The Bottom Line

Bonds are an essential part of many investment portfolios and can be especially useful for generating income or reducing overall risk. But just as important as how much of your portfolio is allocated to bonds is which types you choose. Weighing the trade-offs between risk, return, and taxes can help you build a fixed-income strategy that supports your broader financial goals.