Government Securities

Government securities are direct obligations of the U.S. government. They are widely regarded as safe and profitable investments if held to maturity. These securities are brought to the market on a schedule established by the U.S. Treasury, and the proceeds are used to finance the U.S. government's operations. They are separated into three different maturity groups: Treasury bills, Treasury notes, and Treasury bonds.

Because of their short maturities, Treasury bills do not pay interest, but instead are sold at a discount to their face value and then pay the full face value (also called "par value") upon maturity. For example, a 3-month Treasury bill might sell for $800 and pay $1,000 at maturity.

Treasury notes and Treasury bonds both make semi-annual interest payments. Treasury issues are often used as benchmarks for other comparably maturing securities, because of their liquidity and safety features.

It is important to note that, unlike other investment vehicles, U.S. government securities and U.S. Treasury bills are backed by the full faith and credit of the U.S. government, are less volatile than equity investments, and provide a guaranteed return of principal at maturity.

Mortgage- and Asset-Backed Securities

Most fixed income securities provide you with periodic interest payments over the stated term of the security and repay the principal in full at maturity. Most mortgage- and asset-backed securities, however, make both principal and interest payments monthly, quarterly, or semi-annually over the life of the security. Interest payments are fully taxable; principal payments are not.

• Most mortgage-backed securities are driven by the principal and interest payments on home mortgages. For example, a government-sponsored enterprise that provides housing loans, such as Fannie Mae, will issue a mortgage-backed security to generate capital for lending. The bondholders later receive their interest and principal in the form of monthly payments as the mortgages that the funds were used to finance are paid off.
  
  
• Since homeowners have the right to pay off their mortgages at any time, these monthly payments may include additional payments of principal (known as prepayments).
  
  
• Generally, when interest rates decline, prepayments accelerate beyond the initial pricing assumptions, which could cause the average life and expected maturity of the securities to shorten. Conversely, when interest rates rise, prepayments slow down beyond the initial pricing assumptions. This could cause the average life and expected maturity of the securities to extend, resulting in a decline in market value.
  
  
• When prepayments accelerate due to falling interest rates, principal may have to be re-invested at a lower interest rate than the coupon of the security.
  
  
• Similarly, many asset-backed securities are driven by consumer and home equity loans. For this reason, asset-backed securities structures always contain some form of credit enhancement to bring the credit quality to the desired level.
  
  
• In exchange for the cash-flow uncertainty caused by prepayments, mortgage- and asset-backed securities afford you relative safety (provided you hold them to maturity), liquidity, and superior yields relative to comparable bonds.

Municipal Bonds

Municipal bonds offer investors interest payments that are exempt from federal income taxes, and (for residents of that state) generally exempt from the taxes of the state and/or city in which the bonds are issued. (Income on certain bonds for particular investors, however, may be subject to the federal alternative minimum tax.) While interest income is generally tax-free, capital gains, if any, are subject to taxes.

In addition, some municipal bonds have their principal and interest payments guaranteed by an insurance company, adding an extra layer of protection in the event of default. The insurance does not guarantee the original price, if sold prior to maturity, or current market value.

Municipal bonds are debt obligations of states, cities, towns, municipalities, municipal authorities, and governmental entities. They are typically issued to raise funds to build public facilities, such as schools, courthouses, and libraries, or to finance infrastructure improvements, such as bridges, airports, roads, tunnels, and water and sewer systems.

The table below shows how the yield on a tax-exempt municipal bond compares with the yield on a fully taxable investment in your tax bracket. (State taxes are not considered in this table.)

As an example, based on the table above, in a 35% tax bracket you would have to find a taxable investment that yields more than 7.69% per year so that, after taxes, it would be higher than the tax-free yield of the 5% tax-exempt yield. Please note that this is a hypothetical example for illustrative purposes only, and should not be considered indicative of any specific investment.

Corporate Bonds

• Corporate bonds are issued by corporations to raise money for capital expenditures—building plants, expanding facilities, and so on.
  
  
• Because corporate bonds involve more risk than government bonds, their yields are typically higher.
  
  
• Corporate bonds are usually safer than stocks.
  
  
• The stability of these bonds depends upon the earning power of their issuer. There are many corporate issuers to choose from, most with easily recognizable names.
  
  
• Maturities range from a few months to 40 years, and up to 100 years in a few cases.
  
  
• Corporate bonds are considered senior debt obligations of the company. This means that, if problems arise in the company, the principal and interest must be paid off on the bonds before payments are made for other classes of securities, such as stock dividend payments.
  
  
• The interest paid by corporate bonds is generally fully taxable.

High Yield Corporate Bonds

High yield securities are corporate bonds that have credit ratings below Moody's Baa3 and Standard & Poor's BBB-. These high yield bonds, sometimes called "junk bonds," are typically issued by emerging mid-cap corporations to finance growth. Maturities usually range from seven to 10 years, and interest is paid semi-annually.

High interest income is the most attractive aspect of high yield bonds. The coupon is typically 2%–5% (200–500 basis points) higher than on a like-maturity investment-grade corporate bond. Additionally, if you are an aggressive investor, high yield bonds provide an alternative vehicle to stocks with which you can potentially capitalize on emerging growth industries. As a trade-off for the potentially higher earnings, of course, high yield bonds are subject to greater risk of loss of principal and interest, including default risk, than higher-rated bonds.