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U.S. Government Bonds

U.S. government securities include Treasury bills, notes, and bonds. Treasury bills are short-term obligations (mostly with 13-, 26-, and 52-week maturities) sold by the federal government through competitive bidding. Bills are generally issued in $10,000 minimum denominations, then in $5,000 increments above $10,000. These bills are sold for less than their face value, the discount representing the interest. In this respect, these bills are similar to the Series EE Savings Bonds, which are also sold at a discount but are paid off at full face value at maturity. Treasury notes may run up to 7 years, while Treasury bonds typically have maturities ranging from 5 years to 30 years. Interest income on debt obligations of the federal government is typically exempt from state and local income taxes, but is subject to federal taxes. The relatively low credit risk of government securities, plus their favorable tax treatment, causes them to generally provide a lower pretax yield than that of corporate fixed-income securities with similar maturities. 

Municipal Bonds

Municipal bonds are issued by towns, cities, and regional and local agencies. They are favored by investors in high tax brackets because interest income is generally exempt from both federal income taxes and those, if any, of the state and locality where the bond was issued. Capital gains on all such bonds are treated as normal taxable income, however. The minimum principal amount of a municipal bond is typically $5,000, although they are sometimes issued at a discount. Growing financial problems facing some municipalities have caused the risk level of certain municipal bonds to increase. 

The tax-exempt feature of municipal bonds allows municipalities to borrow money at lower interest rates. These bonds can provide investors with opportunities, on an after-tax basis, to achieve a greater return, for a given amount of risk, than would otherwise be available. To compare the after-tax yields of a taxable bond and a tax-free bond, divide the tax-free rate by the reciprocal of your tax bracket. For example, for an investor in a hypothetical 31% tax bracket, a 6% tax-free bond is the same as an 8.70% taxable yield: computed as 0.06/(1 - 0.31). Such comparisons should be made among bonds of similar credit quality and maturity dates.

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This page is created by Julia Lee '99 and is maintained by Professor Satyananda Gabriel of the Economics Department, Mount Holyoke College, January 1999.