Government bonds are a way that federal, state and local governments raise money to fund their operations. By selling bonds, issuers receive money from investors that they promise to pay back at specified dates, with interest. State- and local-issued government bonds usually are known as municipal bonds. U.S. government securities technically have different names based on their length to maturity, or the date when the government promises to pay the money back. Treasury bills refers to securities maturing in one year or less, while notes refers to securities of up to 10 years in duration. Only investments maturing in more than 10 years are strictly called bonds.
U.S. Government bonds are sometimes called the safest investments in the world, but in reality they are the most secure. They still carry interest rate risk, just like all bonds. When interest rates rise, the price of a bond falls, even government bonds. However, these bonds are backed by the full faith and credit of the U.S. Government, meaning that upon maturity the government guarantees to pay off the bonds at their full maturity value, also known as par value. Along the way, the government also guarantees interest payments.
Municipal bonds are also generally secure, as they often are funded by recurring and predictable revenue, such as the tolls on a newly built bridge. If a bond is not backed by any specific revenue stream, it is known as a general obligation bond. Many municipal bonds, both revenue and general obligation, are insured, meaning if for any reason the municipality has trouble paying the money back, an outside insurance agency will cover any principal or interest payments.
One of the advantages that the U.S. Government bond market has over other government bond markets is its size. The U.S. Government bond market is the largest publicly traded market in the world. What this means as an investor is that you can always get a price for your U.S. Government bond if you want to sell it. The liquidity of the market also means that the spread -- the price difference between what sellers will accept and what buyers will pay -- is very small. This translates into less expensive transaction costs for buyers and sellers in the open market.
While you can buy or sell any type of government securities in the open market, one of the big advantages of the Treasury market is that you can buy directly from the U.S. Government at an auction. The Treasury Department holds regularly scheduled auctions of securities of varying maturities, including everything from four-week bills to 30-year bonds. For most private investors, you enter what's known as a noncompetitive bid, in which you agree to take whatever rate is determined at the auction. The good news about this is that you're guaranteed to receive the current market rate and you don't have to pay a commission to buy.
Municipalities do not have an auction market but they do offer securities directly to customers in public offerings that are commission-free.
All U.S. Government securities are free from state and local income tax. In high-tax states like California and New York, this can be a considerable savings. The tax savings can help counteract the lower interest rates that government securities typically pay, due in part to their low-risk nature.
Municipal bonds benefit from being federally tax-free. If you buy a bond that was issued in the state where you're a resident, you also benefit from the bond being state and local tax-free as well. This "triple tax-free" status of some municipal bonds makes their interest rates very appealing for high-income taxpayers.