What Is a Bond? Types, Yields, and How They're Taxed

A bond is a loan. When you buy a bond, you are lending money to the issuer — a government, a city, or a company — in exchange for two promises: regular interest payments (called the coupon) and the return of your original investment (the principal, or face value) on a specific future date (the maturity).

A $1,000 bond with a 5% coupon and a 10-year maturity pays you $50 a year for 10 years and then returns your $1,000 at the end. That is the entire pitch. Everything else — yield, duration, credit risk, tax treatment — is detail on top of that simple structure.

Bonds matter because they behave differently from stocks. Stocks make you a part owner of a business with unlimited upside and real downside. Bonds make you a creditor with capped upside (the coupon) and a contractual claim to be paid back. A well-built portfolio uses both — stocks for growth, bonds for ballast and income.

Treasuries are bonds issued by the U.S. federal government, backed by its full faith and credit. They are considered the closest thing to a risk-free investment in dollars. They come in three main flavors based on maturity.

Treasury bills (T-bills) mature in one year or less — 4, 8, 13, 17, 26, and 52 weeks. They pay no coupon; instead you buy them at a discount and receive the full face value at maturity. The difference is your yield. T-bills are the cash-like end of the bond market and the building block of money market funds.

Treasury notes mature in 2, 3, 5, 7, or 10 years. They pay a fixed coupon every six months. The 10-year Treasury note is the benchmark used to set mortgage rates, corporate borrowing costs, and the valuation of nearly every other asset.

Treasury bonds mature in 20 or 30 years and also pay a semiannual coupon. Long Treasuries offer the highest yields among Treasuries but carry the most interest-rate risk — when rates rise, their prices fall hard.

Tax treatment: Treasury interest is taxable at the federal level but exempt from state and local income tax. That state-tax exemption is worth real money in high-tax states like California, New York, and New Jersey, and is why a Treasury yielding 4.5% can beat a CD yielding 4.7% for residents of those states.

Municipal bonds are issued by states, cities, counties, and local government entities — to fund schools, hospitals, highways, and water systems. Their defining feature is the tax treatment: interest is exempt from federal income tax, and usually exempt from state and local tax if you live in the issuing state.

That tax shield makes munis especially attractive to investors in high federal brackets. A muni yielding 3.5% federally tax-free is equivalent to a taxable bond yielding about 5.8% for someone in the 37% bracket. The math: 3.5% ÷ (1 − 0.37) = 5.56%; in a high-tax state with the additional exemption, the equivalent yield climbs higher.

Two flavors to know. General obligation bonds (GOs) are backed by the taxing power of the issuer — the safest type. Revenue bonds are backed only by the income from a specific project (a toll road, an airport, a sports stadium) and carry more risk because if the project underperforms, payments can falter.

Trap: munis are a bad fit inside an IRA or 401(k). The tax-advantaged account already shelters interest from federal tax, so you give up the muni's headline benefit and end up with a lower yield than you could have earned with a taxable bond.

Corporate bonds are issued by companies — Apple, ExxonMobil, Ford, anyone. They pay higher yields than Treasuries because the issuer can default. The size of that yield premium (the credit spread) reflects the market's view of the company's creditworthiness.

Investment grade bonds are issued by financially strong companies and rated BBB- or higher by S&P / Baa3 or higher by Moody's. Default rates historically run well under 1% per year. Yields typically sit 0.5 to 1.5 percentage points above comparable Treasuries.

High yield bonds (also called junk bonds) are rated below investment grade. They yield substantially more because default risk is meaningful — historically 2% to 5% a year, with spikes during recessions. They behave more like equity than like Treasuries in a crisis and should be sized accordingly.

Tax treatment: corporate-bond interest is fully taxable at the federal, state, and local level. For that reason, corporate bonds are usually best held in tax-advantaged accounts (IRAs, 401(k)s) where the interest is not taxed annually.

Treasury Inflation-Protected Securities (TIPS) are Treasuries whose principal value rises with the Consumer Price Index. The coupon rate is fixed, but it pays on a principal balance that grows with inflation — so both your interest payments and your final payoff keep up with rising prices. At maturity you receive the inflation-adjusted principal or the original principal, whichever is higher.

Quirk: TIPS owe federal tax annually on the inflation adjustment to principal, even though you have not received the cash yet. This 'phantom income' is the reason most advisers recommend holding TIPS inside an IRA or 401(k).

Series I Savings Bonds (I bonds) are sold directly to individuals through TreasuryDirect.gov. Their interest rate has two parts: a fixed rate set at issuance, plus an inflation rate that resets every six months. You can buy up to $10,000 per year in electronic I bonds plus $5,000 in paper bonds (via tax refund).

I bond perks: interest is exempt from state and local tax, federal tax is deferred until you redeem the bond, and used for qualified higher-education expenses the interest can be fully federally tax-free. Trade-offs: you cannot redeem in the first 12 months at all, and redeeming before five years forfeits the last three months of interest.

When interest rates rise, the prices of existing bonds fall — because new bonds are now being issued with higher coupons, making your old, lower-coupon bond less attractive. When rates fall, existing bond prices rise. This inverse relationship is the single most important thing to understand about bonds.

Duration measures how sensitive a bond's price is to a 1-percentage-point change in interest rates. A bond with a duration of 7 will fall about 7% in price if rates rise 1 point, and rise about 7% if rates fall 1 point. Short-term bond funds typically have durations of 1–3. Total bond market funds run 6–7. Long-term Treasury funds can be 15+ — they move like growth stocks when rates whip around.

Yield to maturity (YTM) is the total annualized return you will earn if you buy the bond today and hold it to maturity, assuming you reinvest the coupons at the same rate. YTM is the number to compare across bonds — not the coupon rate, which only tells you what was promised at issuance.

The simplest approach for most investors is a low-cost bond index fund. BND (Vanguard Total Bond Market ETF) and AGG (iShares Core U.S. Aggregate Bond ETF) hold thousands of U.S. investment-grade bonds for expense ratios under 0.05%. You get instant diversification and never have to think about individual issuers.

For more control, build a Treasury ladder. Buy individual Treasuries directly through TreasuryDirect.gov or a brokerage, staggering maturities so a portion matures every 6 or 12 months. As each bond matures you reinvest into the longest rung. Ladders smooth out interest-rate risk and produce predictable cash flow.

Asset location: hold corporate bonds, TIPS, and high-yield in tax-advantaged accounts. Hold munis in taxable. Hold Treasuries wherever, but lean toward taxable accounts if you live in a high-tax state to capture the state-tax exemption.