Treasury bonds and municipal bonds are income investments that pay investors interest for loaning money to the issuer for set period. Investors purchasing Treasuries represent loans to the federal government to fund the national debt, while municipal bond investments can be used by states, cities and school districts to fund operations or for infrastructure improvements. Treasuries and municipal bonds differ in the way they are taxed as well as their levels of credit risk.
Treasuries
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Treasuries come in many forms: bills, bonds and notes. These investment instruments are backed by the full faith and credit of the U.S. government. Debts issued with maturities of one year or less are referred to as Treasury bills. T-bills are purchased at a small discount and then mature at their full face value of $100. The difference between the prices is the interest earned. For example, a 52-week T-bill that is purchased at $99.25 would mature at $100. The gain of 75 cents would represent an interest rate of .75 percent.
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Treasury notes have maturities of 10 years or less but longer than one year. Treasury bonds have maturities that exceed 10 years. Notes and bonds pay interest every six months. All Treasuries are free of taxation at the state and local levels, but they are taxable at the federal level.
Buying and Selling Treasuries
Treasuries can be purchased and sold through direct interaction with the government, through broker/dealers or through banks. Investors can set up an account with TreasuryDirect for direct purchases of Treasuries either at auction or on the secondary market. TreasuryDirect does not charge transaction or maintenance fees. Treasuries that are purchased at auction or traded in the secondary market through banks and broker/dealers may be charged fees or commissions, depending on the institution.
Municipal Bonds
Municipal bonds, also known as munis, are issued by cities, states, counties, school districts and state agencies to provide funding for infrastructure projects, hospitals, schools and working capital. Interest on munis is usually paid every six months and is free of taxation by states, local governments and the federal government. The two primary types of munis are general obligation and revenue bonds. General obligation bonds are backed by state or local taxes, while revenue bonds are paid with income generated by the project. For example, a revenue bond issued to provide funding to improve toll roads would be paid by a portion of the tolls that are collected. Muni bonds can be purchased at broker/dealers and banks.
Measuring Credit Risk
Unlike Treasuries, municipal bonds are subject to credit risks related to the financial health of the issuer. The credit risks are assessed by agencies including Standard and Poor's, Moody's and Fitch, which assign ratings based on the risk of default. To mitigate credit risk, issuers can elect to insure municipal bond offerings. Bonds backed with insurance are given AAA ratings by all agencies, which indicate the highest level of safety in terms of the return of principal and interest for investors. Municipal bonds that are not insured can be rated in two primary categories: investment grade and high yield. Each agency has its own format for rating the relative risk of bonds in each category. Generally speaking, as credit risk increases, so too will the interest rate on the bond.