Different Types of Bonds Explained: Municipal and Corporate Bonds

Editor’s note: This is part 2 of a series on different types of bonds. Here is part 1 of this series on government bonds.

Bonds and other fixed-interest assets play a valuable role in modern retirement planning. They help balance market risk, create retirement income streams, and keep overall volatility in a financial plan at bay.

Bonds assure that you will be paid interest during their term. Then once the term is over, they repay the original investment, or principal, back to the investor. The ability of a bond to meet these obligations is backed by the financial strength of the bond issuer.  

In this article, we will go over different types of bonds offered by a municipality or a corporation. Before going into further detail about different kinds of bonds, here is a quick sum-up of a bond’s basic features.

Basic Features of Bonds

All types of bonds are issued to raise money for the issuer, whether it be the U.S. government, a municipality, or a corporation. When a bond is issued, it has a defined interest rate, known as the “coupon rate,” that it will pay until the bond matures.

Generally, bonds are issued at what is called “par value.” A standard bond par value is often $1,000.

As an example, let’s say that a bond has a par value of $1,000 and a 6% coupon. In that case, the bond will pay $60 of interest until maturity.

On the other hand, some bonds known as “zero-coupon bonds” are issued at a discount (that is, less than $1,000) and then mature at par value. The difference between the issued value and the maturity value represents how much interest that the bondholder will receive.

How Do Interest Rates Affect Bond Values?

Bond values go up and down in the secondary market. A secondary market is typically a place where investors can buy or sell bonds prior to their maturity.

When interest rates rise, the price of bonds in this market will fall. Now there are new bonds available that are paying a higher rate of interest.

When interest rates fall, then the price of bonds in the secondary market will rise. That is because they are paying higher rates of interest than new bonds.

How Do Credit Ratings Work?

All bonds are rated by bond rating agencies such as Fitch’s, Moody’s, Standard & Poor’s, and A.M. Best. These agencies assign each bond with a specific rating that is based on the financial strength of the issuer.

The higher the rating, the lower the chance that the issuer will default on the bond. For example, a bond with a rating of AAA is considered to be very safe.

How Do Different Types of Bonds Stack Up?

Federal government bonds are usually considered among the “safest” of different bond types. They are backed by the full faith and credit of the U.S. government.

Municipal bonds are generally considered to be the next lowest-risk type of bond. They are backed by one of two sources:

• The taxing authority of the municipality, or
• The revenue that will be generated by the project that the bonds are financing.

Corporate bonds are generally considered to be the type of bond with the most risk. They are ‘only’ backed by the financial strength of the issuing corporation.

Corporate bonds that are rated BB or below are considered to be “junk” bonds and have a higher risk of default. But they also pay the highest rates of interest.

Quick Word on Call and Put Features

Both municipal and corporate bonds may also come with a call or put feature. A call feature allows the issuer to recall the bonds early at a pre-set date in the future. This is done to protect the issuer against falling interest rates.

A put feature gives the investor the chance to redeem the bond early within a pre-set window of time. The investor would do this if interest rates have risen since the bond was initially purchased.

Municipal Bonds

Municipalities, such as cities and states, have the authority to levy taxes, if necessary, in order to meet their financial obligations. Municipal bonds pay lower rates of interest than corporate bonds.

Interest earnings from municipal bonds are usually income tax-free at the federal and state levels. However, certain conditions apply, such as residence in the state of bond issue.

If you buy a municipal bond issued from someplace that you don’t live in, the interest may only be tax-exempt at the federal level. Those who earn large amounts of municipal bond interest may also incur the alternative minimum tax.

For that reason and others, it’s wise to consult with a tax professional if you fall into this category.

Different Kinds of Municipal Bonds

There are two basic types of municipal bonds: revenue and general obligation.

Both types of bonds can largely eliminate the risk of default by purchasing insurance that guarantees the interest payments to investors if the issuer should become unable to do so for any reason.

Like all other types of bonds, municipal bonds are assigned a credit rating by the rating agencies.

Revenue Bonds

Revenue bonds are issued by a municipality. The money to make the interest payments on these bonds is received from the revenue generated by the municipal project.

What sorts of projects might these be? It could be a sports stadium, toll road, or other infrastructure-related facility that can be used to make money for the issuer.

General Obligation Bonds

These kinds of bonds are backed by the taxing power of the issuer. Municipal bonds that are issued by cities and states are GO bonds. If necessary, those two entities can raise taxes in order to be able to make their interest payments.

The rating of a GO bond can be affected if the issuer is experiencing financial difficulties or has declared bankruptcy.

Corporate Bonds

Corporate bonds often pay higher interest than municipal bonds. However, the interest that they pay is fully taxable at all levels.

Like other types of bonds, corporate bonds are rated by the ratings agencies and often have either put or call features. That being said, here is a good thing to keep in mind.

A bond issued by McDonald’s Corporation is, by definition, riskier than a government bond.

But think for a minute: which of those two entities is making a profit? Which one can stick to a budget? Which one has trillions and trillions in debt? This is one reason that U.S. government bonds can have lower credit ratings than those of other countries, such as Canada.

Convertible Bonds

There is a type of corporate bond that allows the bondholder to cash in the bond for a preset number of shares of stock in the issuer. This conversion feature can make the bond worth more than its par value.

If the price of the stock rises, then the price of the bond will rise in the secondary market as well. Of course, if the stock price falls, then the lowest value the bond would fall to would be its par value. But that assumes that the bondholder holds it until maturity.

Municipal and corporate bonds can provide tax-advantaged growth or income with a reasonable degree of risk. But they aren’t the only financial vehicle that can do this.

Bond Alternatives Available

Fixed and fixed indexed annuities also offer a guarantee of principal that is backed by a life insurance company. Life insurance companies must hold at least a dollar in their cash reserves for every dollar of outstanding annuity premium that they receive.

Fixed annuities pay a guaranteed interest rate that is often slightly higher than certain bonds, and they can have shorter maturity periods as well. Fixed index annuities don’t have a guaranteed interest. However, they often provide higher growth over time than what fixed annuities have seen.

You can also tap an annuity for a guaranteed lifetime income stream, no matter how that you may live. One downside for annuities vs. bonds is that annuities typically don’t have as much liquidity. Your financial professional can go over this drawback, and other advantages as well as disadvantages, with you.

Exploring Your Options for Different Goals

Consult your financial advisor for more information on bonds and annuities and which option may be the best for you. If you are looking for a financial professional to assist you, many independent financial professionals are available at SafeMoney.com.

You can use our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your goals and situations as well as explore a potential working relationship. Should you need a personal referral, please call us at 877.476.9723.