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Sometimes the government, as well as large companies, needs to borrow money to operate. Instead of seeking a traditional loan through a financial institution they instead issue a bond or a debt security. The debt security operates in a similar manner as an I.O.U. Therefore, when you purchase a bond you are lending money to a government, municipality, corporation or a federal agency. Each of these entities is considered the issuer. In exchange for the loan, the issuer agrees to pay you a specified interest rate during the life of the bond in addition to the initial face vale of the bond (the principal) when it matures.

This Risk

The primary risk associated with bonds is the issuer's potential to not be able to meet the obligations of the terms of the loan. When this happens, the issuer goes into default and you could lose money. Some bonds are riskier than others; therefore, bonds are issued an investment grade. This investment grade is a rating that determines the likelihood of whether or not the bond-issuer will be able to make its interest payments on time and repay its debt at time of maturity. See bond rating table below for more information:

Source: Standard & Poor's

Bond Types

The four more common types of bonds you can choose from include: U.S. Government Securities, Municipal Bonds, Corporate Bonds, Mortgage and Asset Bonds Backed Securities. Most bonds have a face value of $1,000 per bond. In many cases, there are a mandatory minimum number of bonds you can purchase.

U.S Government Securities

U.S. Government bonds are issued by the U.S. Department of the Treasury. U.S. Treasury securities include:

• U.S. Treasury bill or T-Bill
• Negotiable debt obligation issued by the U.S. Government and backed by its full faith and credit.
• Issued in denominations of $1,000, although brokerage firms may impose a minimum purchase order.
• Maturity dates from 90 days to 1 year.
• Interest is generally exempt from state and local income taxes.
• Interest is paid at maturity and is the difference between the cost to purchase the bill and the face value received at maturity.
• U.S. Treasury note
• Negotiable debt obligation issued by the U.S. Government and backed by its full faith and credit.
• Issued in denominations of $1,000, although brokerage firms may impose a minimum purchase order.
• Maturity dates range from 2 to 10 years.
• Interest is paid semi-annually.
• U.S. Treasury bond
• Negotiable, coupon-bearing debt obligation issued by the U.S. Government and backed by its full faith and credit.
• Issued in denominations of $1,000, although brokerage firms may impose a minimum purchase order.
• Maturity dates from 10 to 30 years.
• Interest payments are exempt from state and local taxes.
• Interest paid semi-annually.
• U.S. government issued zero-coupon bond or accrual bond
• Issued at a discount that varies depending on the length of the maturity.
• Pays no interest; instead, pays a higher par value at maturity than the face value at issue.
• Taxes due annually on accrued interest (except with tax-exempt municipal zeros).
• Savings bond or U.S. Savings Bond
• Registered, non-callable, non-transferable bond issued by the U.S. Government and backed by its full faith and credit.
• Face value ranges from $50 to $10,000.
• Issued in 3 types: Series EE, Series HH, Series I.
• Interest payments are exempt from state and local taxes.

Municipal Bonds

State or local governments issue municipal bonds to fund civic projects. One potential advantage of investing in municipal bonds is that these bonds are deemed to be public purpose bonds and generally pay interest free from federal and/or state income tax. All capital gains earned from the sale of a municipal bond are fully taxable and may be taxed as income if the bond was purchased at a certain discount level and is sold prior to maturity.

Generally you will receive a lower interest rate on tax-free bonds since you are benefiting from the tax advantage. You should consult your accountant depending on your specific tax situation.

When thinking of purchasing municipal bonds, as a rule of thumb, you should calculate the taxable equivalent yield. This is the actual yield needed on a taxable investment in order to match the tax-free return offered on a municipal bond. Use the following equation to help you:

Taxable Equivalent Yield = Tax-exempt yield divided by (1 - your marginal tax rate)

For example, if you are in the 33 percent tax bracket and earn 5.5 percent on your tax-exempt municipal bond, 8.2 percent is the equivalent yield on a taxable investment.

Corporate Bonds

Corporate bonds are issued by companies to raise capital. These bonds tend to be more risky than government bonds but tend to pay a higher interest rate upon maturity.

Corporate bonds commonly have the following features:

• Par value of $1,000;
• Minimum purchase is typically $5,000.