Types of Bonds

U.S. Treasury securities are the safest investments available anywhere, backed by the full faith and credit of the federal government, which is why their yields set the baseline that nearly every other bond is priced against. They come in a family of forms: short-term bills, medium-term notes, long-term bonds, an inflation-protected version (TIPS), and the savings bonds (EE and I). What they all share is the tax treatment, interest is taxable at the federal level but exempt from state and local tax. The table below lays out the full lineup.

Here is the full breakdown of the U.S. government securities the SIE expects you to recognize:

Every Treasury security shares three traits: it is backed by the full faith and credit of the U.S. government (zero default risk), it is exempt from state and local income tax, and its interest is subject to federal income tax.

STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon Treasuries. They are created when an approved broker-dealer takes a regular Treasury note or bond and strips it apart, turning each individual coupon payment and the final principal payment into its own separate zero-coupon security. A 10-year note with semiannual coupons becomes 21 separate STRIPS, the 20 coupons plus the one principal payment, each maturing on the date its cash flow was originally due.

Because there are no periodic payments, a STRIP is sold at a discount and matures at par, with the price appreciation making up the entire return. It keeps the Treasury's best traits: the full faith and credit backing and the exemption from state and local tax.

The catch is phantom income. The IRS makes the holder report and pay tax each year on the accreted portion of the discount, even though no cash arrives until maturity. That is why STRIPS are usually held in tax-deferred accounts like IRAs, where phantom income does not matter. They fit a known future need cleanly, funding a specific college or retirement year, since the exact payoff date and amount are fixed, and they carry higher duration than coupon Treasuries of the same maturity.

Municipal bonds are issued by state and local governments, and their headline feature is tax treatment: the interest is generally exempt from federal income tax. That exemption is the whole reason munis can offer lower stated yields than taxable bonds and still come out ahead for the right investor. They come in two main flavors.

General obligation (GO) bonds are backed by the issuer's full taxing authority and repaid out of general tax revenue. Because they put taxpayers on the hook, they usually require voter approval. Revenue bonds, by contrast, are backed only by the income from a specific project, the tolls from a highway, the fees from an airport or hospital, so they do not require voter approval. With repayment tied to one project rather than the full tax base, revenue bonds are generally considered riskier than GOs.

A few muni-specific details show up reliably on the exam.

Tax-equivalent yield answers the practical question: how big a taxable yield would I need to match this tax-free muni? The formula is the muni yield divided by one minus your tax rate:

Tax-Equivalent Yield = Municipal Yield ÷ (1 − Tax Rate)

So a 3.5% muni for an investor in the 32% bracket is worth 3.5% ÷ (1 − 0.32) = 3.5% ÷ 0.68 = 5.15%. That investor would need a taxable bond yielding at least 5.15% to do better than the muni after tax.

A muni is triple tax-free when the investor lives in the same state as the issuer, exempting the interest from federal, state, and local tax all at once, which makes in-state munis especially attractive in high-tax states. One exception to watch: interest on certain private activity bonds (those financing non-governmental projects like airports or stadiums) can be subject to the Alternative Minimum Tax, even though it escapes regular federal income tax.

Corporate bonds are issued by companies to raise capital, and because a corporation can default in ways the U.S. government cannot, they pay higher yields than government bonds to compensate for that credit risk. They fall into a few buckets: secured bonds backed by specific collateral, unsecured bonds (called debentures) backed only by the issuer's general credit, and convertible bonds that can be exchanged for common stock.

Agency securities are issued by government-sponsored enterprises (GSEs) such as GNMA, FNMA, and FHLMC, and they are best known for mortgage-backed securities. One distinction the exam draws: GNMA (Ginnie Mae) is backed by the full faith and credit of the U.S. government, while FNMA (Fannie Mae) and FHLMC (Freddie Mac) are not, they carry an implied but not explicit government backing.

Callable bonds

A callable bond gives the issuer the right to redeem it early, usually after a call-protection period. Issuers call when interest rates fall, refinancing into cheaper debt exactly the way a homeowner refinances a mortgage. That hands the investor reinvestment risk, the principal comes back early and has to be reinvested at the new, lower rates, so callable bonds pay a higher coupon to compensate, and their yield to call runs below YTM for a premium bond.

Putable bonds

A putable bond is the mirror image: the investor can sell it back to the issuer at par before maturity. Investors put bonds when rates rise, handing back the old bond and reinvesting at the higher rates. Because that feature protects the investor, putable bonds carry a lower coupon.

Zero-coupon bonds

Zero-coupon bonds pay no periodic interest at all. They are sold at a deep discount and mature at par, with the gap being the entire return. Watch the tax trap: they throw off phantom income, the IRS taxes the annual accreted interest as ordinary income even though no cash is received, which makes zeros best suited to tax-deferred accounts. With every dollar arriving at maturity, a zero has the highest duration, and therefore the most interest-rate risk, of any bond.

Convertible bonds

A convertible bond can be turned into a fixed number of common shares. Its conversion ratio is par divided by the conversion price, and its parity price is the bond's market price divided by that conversion ratio. Convertibles pay a lower coupon than comparable straight bonds because the conversion right has value, giving the holder a bond's downside floor with some of a stock's upside.

Money market instruments are short-term debt securities with maturities of one year or less. They are prized for liquidity and safety, which makes them low-risk parking spots for cash. The ones the SIE expects you to know:

• Treasury bills (T-bills): short-term government securities (4 to 52 weeks) sold at a discount and maturing at par, with no coupon, the difference is your return.
• Commercial paper: unsecured, short-term debt issued by large, creditworthy corporations (1 to 270 days) to fund near-term obligations, usually in $100,000 minimums.
• Certificates of deposit (CDs): bank time deposits at a fixed rate. Negotiable (jumbo) CDs of $100,000 or more can trade in the secondary market, and CDs are FDIC-insured up to $250,000.
• Banker's acceptances (BAs): short-term drafts drawn on a bank, used mostly in international trade, where the bank guarantees the obligation.
• Repurchase agreements (repos): short-term borrowing where securities are sold with an agreement to buy them back later at a higher price.

Municipalities also issue short-term notes to smooth out cash flow or bridge financing until a long-term bond deal closes. They are named for whatever revenue is expected to repay them:

• TANs (tax anticipation notes): repaid from upcoming tax receipts.
• RANs (revenue anticipation notes): repaid from expected revenue, such as a project or state and federal funds.
• BANs (bond anticipation notes): repaid from a future long-term bond issue.
• TRANs: a combination of tax and revenue anticipation.

Most munis are tax-exempt, but there is a taxable exception worth knowing: Build America Bonds (BABs), created under the 2009 Recovery Act, pay taxable interest, with the issuer receiving a federal subsidy to offset the higher borrowing cost.

Credit rating agencies, primarily Moody's, S&P, and Fitch, grade how likely an issuer is to repay. The relationship is straightforward: a higher rating means lower risk, and lower risk means a lower yield.

The whole scale splits at one line: bonds rated BBB/Baa or higher are investment grade; anything below is speculative, the high-yield or junk bonds, which pay more precisely because they are more likely to default.

When a bond changes hands between coupon dates, the buyer owes the seller the accrued interest, the interest that has piled up since the last coupon. That is only fair: the seller held the bond for part of the period and earned that slice. So the buyer pays the bond's price plus accrued interest (a quote "and interest") and is made whole on the next coupon date, when the buyer collects the full coupon. Two day-count conventions govern the math: corporate and municipal bonds use 30/360 (every month counts as 30 days, the year as 360), while U.S. government bonds use actual/actual (the real number of days).

The SIE tests two international bond labels at a recognition level, and students mix them up because the names do not announce what sets them apart.

A Eurobond is denominated in a currency different from the country where it is issued, the classic case being a U.S. dollar bond sold in London or Tokyo. Despite the name it is not specifically European; the term is just historical. Eurobonds are not registered with the SEC, typically pay interest gross with no withholding tax, and appeal to issuers for their lighter regulation and global reach.

A Yankee bond runs the other way: it is issued in the United States by a foreign entity, a foreign government or corporation, and denominated in U.S. dollars. Because it is sold here it must be registered with the SEC and comply with U.S. securities laws, and since it pays in dollars it removes currency risk for the U.S. buyer.