Debt issued by a government—whether it’s local, state or federal—is generally a safe investment. Most government debt is backed by a “full faith and credit” pledge, which is a commitment to pay back the debt no matter what. It is widely accepted that the United States government will never default on its debt obligations, making its bonds virtually risk-free.
U.S. Government Bonds
The U.S. government can issue short-term, medium-term and long-term debt, often referred to simply as treasuries. Since treasuries have a low risk of default, they also offer low interest rates. Therefore, these debt instruments are usually used as safe havens for investors—not a way to get high returns. Another advantage treasuries offer to investors is tax exemption on interest earned from local and state taxes. Here are the four main types of treasuries you can invest in.
- Treasury bills: Also known as T-bills, these are securities issued by the government with the shortest length of maturity. The maturity is the date at which the final payment and principal of a security is due. Maturities for any given treasury bill can last from a few days up to 52 weeks. Like zero-coupon bonds, T-bills do not pay interest prior to maturity. Instead, they are sold at a discount from their face value in order to create a positive yield to maturity.
- Treasury notes: These have maturities from two to 10 years and pay interest every six months. The 10-year Treasury note is often quoted in any discussions of the performance of the U.S. government bond market.
- Treasury bonds: These are government securities with the longest maturities, ranging from 20 to 30 years. The bonds are usually issued in denominations of $1,000 and interest is paid semi-annually.
- Treasury Inflation-Protected Securities: Also known or TIPS, these are inflation-indexed securities whose principal is adjusted by changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of five, 10 and 30 years.
Municipal bonds, also known as munis, include all other government-issued bonds. This includes states, counties, cities and other municipalities, including state authorities, utilities, airports and schools districts. Interest on municipal bonds is usually exempt from federal taxes, as well as taxes within the state in which they are issued. For example, a California resident that invests in a California bond would not have to pay state or federal income taxes on the interest earned from the bond. Some municipal bonds, however, are taxable. These bonds include those issued by a municipality for a purpose that does not provide a major benefit to the public. For example, bonds issued by a public authority to finance a sports arena would likely be taxable.
Types Of Municipal Bonds
There are two types of municipal bonds you can invest in. General obligationbonds are secured by the issuer’s full faith, credit and taxing power. This means the issuer may repay its obligations through its taxation power. In most cases, general obligation bonds are voter-approved. Revenue bonds are secured by specific revenues, which may be derived from tolls, fees, rents, or other payments such as airports and water utilities. Most public transportation systems have authorities, like New York City’s Metropolitan Transportation Authority or the Metropolitan Atlanta Rapid Transit Authority, which can issue bonds to finance transportation projects.
Treasuries v. Munis
Both treasuries and munis offer tax advantages, relative low risk of default and low volatility, compared to other fixed income securities. In addition, both have a high level of liquidity. You can buy and sell either on a secondary market. That means you can easily sell your bonds if you need cash without incurring a tax penalty.
While there are many similarities, there are also several differences you should consider when deciding which type of investment to put your money in.
The Safer Bet: Treasuries
Although both forms of debt can be safe investments, municipal bonds have greater risks associated. The risk refers to how likely an issuer is to make payments on time and in full. Issuers are assigned credit ratings from agencies, including Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, based on these risks. A triple-A rating is the highest credit rating an issuer can receive, and a C or D is the lowest.
The United States had the highest credit ratings by all three ratings agencies until August 5, 2011, when Standard & Poor’s knocked it down to the second highest rating of AA+. The other two agencies maintained their triple-A ratings.
U.S. states are generally rated in the A category. Lower ratings are usually assigned to smaller municipalities that are likelier to default. Municipal bonds traditionally have had very low rates of default, but they do occur.
There are many municipal bonds that have triple-A ratings, but there are also many that have below investment grade ratings. Since the United States carries top ratings, Treasuries are generally the safer investment.
If munis have the potential to be riskier, it means they also have the potential to offer higher returns. If you’re looking for higher returns, you should invest in lower-rated municipal bonds, not treasuries. Additionally, the municipal bond market is a $3.7 trillion market that offers thousands of issuers to choose from. You have the flexibility to invest in triple-A rated muni bonds, as well as lower rated bonds that offer greater returns. With treasuries, you can only invest in triple-A rated debt.
Tax Advantages: Munis
Municipal bonds have the potential to save you from state and local taxes in addition to federal taxes, while interest on treasuries is only exempt from federal tax. Of course, it depends on where you live, as well as your federal tax bracket. Investing in municipal bonds usually makes more sense for investors that fall within the top federal tax bracket. When you buy a muni bond, you are forgoing a higher yield you could get on, say, a corporate bond, in exchange for not having to pay taxes. For most, buying a taxable bond that pays a higher interest rate would result in a greater return. Before you decide, you should do the math or ask your accountant to do the math for you.
If you’re looking for safe and stable, but low, returns, government bonds are likely a good investment for you. Whether you should invest in municipal bonds or treasuries depends on your goals for returns and savings from taxes.