Bonds

There are seven main issuer categories:

1.) Treasury bonds;

2.) other U.S. government bonds;

3.) investment-grade corporate bonds (high quality);

4.) high-yield corporate bonds (low quality), also known as junk bonds;

5.) foreign bonds;

6.) mortgage-backed bonds; and

7.)municipal bonds.

Here's what you need to know about each of the seven classes of bonds:

1. Treasury bonds

Treasuries are issued by the federal government to finance its budget deficits. Because they're backed by Uncle Sam's awesome taxing authority, they're considered credit-risk free. The downside: Their yields are always going to be lowest (except for tax-free munis). But in economic downturns they perform better than higher-yielding bonds, and the interest is exempt from state income taxes.

2. Other U.S. government bonds

Also called agency bonds, these bonds are issued by federal agencies, mainly Fannie Mae ( FNM) (the Federal National Mortgage Association) and Ginnie Mae (the Government National Mortgage Association). They're different from the mortgage-backed securities issued by those same agencies, and by Freddie Mac ( FRE) (the Federal Home Loan Mortgage Corp.). Agency yields are higher than Treasury yields because they are not full-faith-and-credit obligations of the U.S. government, but the credit risk is considered minimal. Interest on the bonds is taxable at both the federal and state levels, however.

3. Investment-grade corporate bonds

Investment-grade corporates are issued by companies or financing vehicles with relatively strong balance sheets. They carry ratings of at least triple-B from Standard & Poor's, Moody's Investors Service or both. (The scale is triple-A as the highest, followed by double-A, single-A, then triple-B, and so on.) For investment-grade bonds, the risk of default is considered pretty remote. Still, their yields are higher than either Treasury or agency bonds, though like most agencies they are fully taxable. In economic downturns, these bonds tend to underperform Treasuries and agencies.

4. High-yield bonds

These bonds are issued by companies or financing vehicles with relatively weak balance sheets. They carry ratings below triple-B. Default is a distinct possibility. As a result, high-yield bond prices are more closely tied to the health of corporate balance sheets. They track stock prices more closely than investment-grade bond prices. "High-yield doesn't provide the same asset-allocation benefits you get by mixing high-grade bonds and stocks," observes Charles Schwab Chief Investment Officer Steve Ward.

5. Foreign bonds

These securities are something else altogether. Some are dollar-denominated, but the average foreign bond fund has about a third of its assets in foreign-currency-denominated debt, according to Lipper. With foreign-currency-denominated bonds, the issuer promises to make fixed interest payments -- and to return the principal -- in another currency. The size of those payments when they are converted into dollars depends on exchange rates. If the dollar strengthens against foreign currencies, foreign interest payments convert into smaller and smaller dollar amounts (if the dollar weakens, the opposite holds true). Exchange rates, more than interest rates, can determine how a foreign bond fund performs.

6. Mortgage-backed bonds

Mortgage-backeds, which have a face value of $25,000 compared to $1,000 or $5,000 for other types of bonds, involve "prepayment risk." Because their value drops when the rate of mortgage prepayments rises, they don't benefit from declining interest rates like most other bonds do.

7. Municipal bonds

Municipal bonds -- often called "munis" are issued by U.S. states and local governments or their agencies, and they come in both the investment-grade and high-yield varieties. The interest is tax-free, but that doesn't mean everyone can benefit from them. Taxable yields are higher than muni yields to compensate investors for the taxes, so depending on your bracket, you might still come out ahead with taxable bonds.