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Taxonomy of Fixed-Income Securities

Fixed-income instruments are categorized by their issuer, credit risk profiles, and tax treatment under the Internal Revenue Code.

U.S. Treasury Securities

Issued by the U.S. Department of the Treasury and backed by the full faith and credit of the federal government, Treasuries carry negligible credit risk. The interest income is exempt from all state and local income taxes under federal law, though it remains subject to federal income tax.

Treasury Bills (T-Bills): Short-term debt with maturities ranging from 4 to 52 weeks. They are issued as zero-coupon securities at a discount to par and mature at face value. The minimum purchase is $100 via TreasuryDirect.gov or a brokerage account. They are highly liquid cash equivalents.
Treasury Notes and Bonds: Fixed-rate nominal debt paying semi-annual coupons. Notes have maturities between 2 and 10 years; bonds are long-term instruments maturing in 20 or 30 years.

Treasury Inflation-Protected Securities (TIPS) TIPSs are designed to eliminate purchasing power risk. The principal value is adjusted daily by an index ratio derived from the consumer price index for all urban consumers (CPI-U) — Treasury publishes a monthly reference index and interpolates it across each day — while the coupon rate stays fixed. Interest is paid semi-annually on whatever the inflation-adjusted principal happens to be on the payment date, so the dollar coupon rises with inflation even though the rate does not. At maturity you receive the greater of the adjusted principal or the original par value, which makes the principal deflation-protected as well.

The tax problem is that the inflation adjustment is income in the year it accrues, with no cash attached until maturity. TIPS are governed by the inflation-indexed debt instrument rules of Treas. Reg. §1.1275-7, which apply the coupon bond method: the annual principal accretion is taxed as OID under IRC §1272 as it happens. Hold TIPS in a traditional IRA or 401(k) instead of a taxable account — the phantom income makes them among the most tax-inefficient instruments a high-bracket investor can own outside a wrapper.

Series I Savings Bonds (I Bonds) I Bonds are non-marketable savings bonds designed to protect personal cash reserves from inflation. They earn interest based on a composite rate that combines a fixed rate (set at purchase) and a variable semiannual inflation rate linked to the CPI-U. Interest accrues monthly and compounds semiannually.

From a tax perspective, I Bonds are efficient: federal income tax can be deferred entirely until redemption or maturity (up to 30 years), and the interest is exempt from all state and local income taxes. If redeemed to pay for qualified higher education expenses, the interest may be completely exempt from federal income tax under the Education Savings Bond Program of IRC §135, “Income from United States savings bonds used to pay higher education tuition and fees”, which phases the exclusion out over an income range that catches most readers of this book ( IRS Pub. 970 has the current figures).

However, the Treasury imposes structural purchase limits:

Individual Limits: You are limited to purchasing $10,000 in electronic I Bonds per calendar year per Social Security Number (SSN).
Trust Loophole: A trust opens its own TreasuryDirect entity account, and each entity account carries its own $10,000 annual limit. A revocable living trust qualifies even though it uses the grantor’s own SSN as its taxpayer ID — no separate EIN is required, because the personal account and the trust account are distinct account types even under the same number. Couples with individual trusts can allocate $40,000 annually across their four accounts.
Gifting Box Loophole: You can purchase additional I Bonds as gifts for another individual (e.g., your spouse) and store them in a virtual “gift box” on TreasuryDirect. The gift bonds begin earning interest and satisfy the 12-month holding period immediately based on the purchase date. The purchase counts toward the recipient’s $10,000 annual limit only in the year the gift is delivered. This allows you to lock in favorable fixed rates on hundreds of thousands of dollars and gradually distribute them over future tax years.

You must hold I Bonds for a minimum of 12 months. Redemptions within the first five years incur a penalty equal to the last three months of interest; after five years, no penalty applies.

Series EE Savings Bonds Series EE bonds are non-marketable savings bonds with a unique statutory floor: the U.S. Treasury guarantees that an EE bond will double in value exactly 20 years after purchase, regardless of the stated fixed interest rate. This step-up equates to a contractually locked-in compound annual growth rate (CAGR) of exactly 3.526%, completely free of state and local income taxes.

The stated fixed coupon rate (often 0.10% to 2.50%) is irrelevant. If the accrued interest from the stated rate fails to double the bond’s value by year 20, the Treasury makes a one-time upward adjustment to fulfill the guarantee. If the bond is redeemed before year 20, you receive only the posted coupon rate, turning the asset into a low-yielding investment. Therefore, EE bonds must be treated as a strict 20-year commitment. They are limited to $10,000 per SSN per calendar year.

Municipal Bonds

Municipal bonds (munis) are debt obligations issued by state and local governments, school districts, and public authorities. The defining characteristic of munis is that their interest income is excluded from federal gross income under IRC §103, “Interest on State and local bonds” — an exclusion, not a preferential rate, so it never enters taxable income at all. It does still get reported, and it still counts toward the MAGI that drives IRMAA surcharges and the taxation of Social Security, so “tax-free” is not the same as “invisible.” If you reside in the state of issuance, the interest is typically exempt from state and local income taxes as well. Look up any specific issue’s official statement, trade history, and continuing disclosures on the MSRB’s EMMA system before buying it in the secondary market.

General Obligation (GO) Bonds: Backed by the full faith, credit, and taxing power of the issuing municipality. GO bonds carry low credit risk.
Revenue Bonds: Repaid solely from the cash flows generated by a specific public project (e.g., highway toll systems, water utilities, or airports). They carry higher yield premiums and default risk than GO bonds.
Conduit Bonds: Issued by a public authority on behalf of a private entity (such as a private university, hospital system, or housing development). The private entity is solely responsible for debt service; if it defaults, the municipal issuer has no obligation to pay the bondholder.

“Tax-free” applies to the coupon, not to the price you paid. Two rules catch buyers in the secondary market, and the rate environment since 2022 has put most older munis on the wrong side of the first. Buy a tax-exempt bond below par and the market discount is not tax-exempt: under IRC §1276, “Disposition gain representing accrued market discount treated as ordinary income” it is ordinary income when the bond matures or is sold, unless it is small enough for the de minimis rule of IRC §1278(a)(2)(C) — less than 0.25% of par for each full year to maturity. A 2% discount on a bond with ten years left is under the 2.5% line and comes back as capital gain; a 4% discount on the same bond is ordinary income at 37% plus state. Price the discount against that threshold before you call a secondary-market yield “tax-free.” Buy above par and the premium must be amortized against your basis each year under IRC §171(a)(2) with no deduction for it, so the premium is a prepaid reduction of the tax-exempt coupon, not a loss you will get to claim. Neither rule bites on a fund, which nets both through its distributions.

Tax-Equivalent Yield (TEY) To compare a municipal bond’s return to a taxable corporate bond or Treasury, you must calculate its tax-equivalent yield. The State and Local Tax (SALT) deduction of IRC §164(b)(6) is capped at $40,400 for 2026 under OBBBA — but the cap grinds down by 30 cents per dollar of MAGI above $505,000 and bottoms out at $10,000, which a top-bracket reader’s property tax and state income tax exhaust several times over (section “Tax Deductions of The Mortgage Interest”). At the incomes this section is written for, the marginal state income tax dollar is therefore not deductible federally, and federal, state, and Net Investment Income Tax (NIIT) rates stack additively. The full-stack TEY for an in-state municipal bond is:

TEY = \frac{Y_{muni}}{1 - [T_{f} + T_{s} + T_{NIIT}]}

Where:

— Yield on the municipal bond
— Federal marginal income tax rate (up to 37%)
— State marginal income tax rate (up to 13.3% in California — the 12.3% top bracket plus the 1% Behavioral Health Services Tax, already combined in that figure, not stacked on top of it)
— Net Investment Income Tax rate under IRC §1411 (3.8% for high earners)

For a high-income California resident in the top brackets, the total tax drag is $0.37 + 0.133 + 0.038 = 0.541$ (54.1%) — the 13.3% state figure already includes the 1% Behavioral Health Services Tax stacked on the 12.3% top bracket. An in-state California muni yielding 4.00% delivers a TEY of:

TEY = \frac{0.04}{1 - 0.541} = 8.71 %

A fully taxable bond — a corporate bond, or an out-of-state muni — would need to yield 8.71% to deliver the same after-tax cash flow. Note that this comparison holds only against ordinary interest income. A qualified-dividend equity is taxed at $20 + 3.8 + 13.3 = 37.1 %$ instead of 54.1%, so the same 4% muni is equivalent to only a 6.36% qualified dividend yield. Compare munis against bonds, not stocks. Purchasing an out-of-state municipal bond instead exposes the interest to state income tax, stripping away the state tax shield and reducing the after-tax yield significantly. For high-bracket residents of high-tax states, in-state municipal bonds are an efficient fixed-income allocation.

Alternative Minimum Tax (AMT) and Private Activity Bonds While municipal interest is exempt from regular federal income tax, interest from Private Activity Bonds (PABs) — municipal debt issued to finance private enterprise projects such as sports arenas, airports, or industrial facilities — is treated as a tax preference item under IRC §57(a)(5), “Items of tax preference”. Under the Alternative Minimum Tax (AMT) system, PAB interest is taxed at rates up to 28%.

If you are projected to trigger the AMT, buy “AMT-free” municipal bonds or funds that screen out PABs; if you are not, avoid them — the screening constraint costs roughly 10 to 20 basis points of yield you have no reason to give up.

Run that projection more carefully for 2026 than you did in prior years, because OBBBA moved the AMT against you in two directions at once. The exemption phase-out thresholds were reset to $500,000 (single) and $1,000,000 (joint) — below where indexing would have carried the TCJA figures — and the phase-out rate doubled from 25% to 50%, so the exemption now burns off twice as fast above the threshold. A married couple with $1.1 million of AMT income loses $50,000 of exemption in 2026 where the same facts cost $25,000 in 2025.

That matters most to exactly the reader this section is written for: the ISO exerciser. The bargain element on an ISO exercise is an AMT preference item, so a large exercise both creates the AMT exposure and pushes you into the steeper phase-out. Sequence the exercise and the muni purchase in the same planning conversation instead of separately — section “Alternative Minimum Tax: Understanding and Navigating Its Impact” works the computation.

Corporate Bonds

Corporate bonds are debt securities issued by public and private corporations. They are classified into two broad categories:

Investment-Grade: Rated BBB- (S&P) or Baa3 (Moody’s) and above. Issued by financially stable companies with low default probabilities. They offer modest yields and are highly liquid.
Speculative-Grade (High-Yield / Junk): Rated below BBB-/Baa3. Issued by highly leveraged firms or distressed companies. Spreads over comparable Treasuries typically run 300 to 600 basis points in ordinary conditions and blow out past 1,000 in a credit event. Annual issuer default rates peaked near 11–13% in each of the last three major cycles (1991, 2001–02, 2009), with cumulative losses over a full downturn running considerably higher. The behavior that matters for allocation: high-yield trades like an equity proxy in a drawdown, losing value exactly when your stocks do, which disqualifies it as portfolio ballast — see section “Five Fallacies of Fixed-Income Markets”.

The bond’s indenture — the contract between issuer and bondholders, administered by a trustee — contains protective covenants, which can be affirmative (e.g., maintaining minimum liquidity ratios) or negative (e.g., restricting the issuance of senior debt). You must distinguish between secured bonds (backed by specific collateral) and unsecured debentures (backed only by the cash-generating power of the firm).

Agency Mortgage-Backed Securities

The bond index your fund tracks is roughly a quarter agency mortgage-backed securities (MBS) — pools of residential mortgages guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac — so you own them whether or not you chose to. Credit risk is negligible; the risk is the borrower’s option. Every mortgage can be prepaid, and homeowners refinance when rates fall and stay put when rates rise, so the security shortens exactly when you would want it long and lengthens exactly when you would want it short. That is negative convexity, and it is why an MBS sleeve gains less than a Treasury of matched duration in a rally and loses about as much in a selloff. The yield spread over Treasuries is the price of that option. Hold agency MBS through the aggregate fund if you want the spread; do not reach for an MBS fund as a Treasury substitute in the ballast role, because the convexity works against you in the demand-shock rally the ballast exists for. Interest is fully taxable at the federal and state level — the state exemption of Treasuries does not extend to agency guarantees.

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