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Are you are intrigued by bonds but not quite sure how they work? Or maybe you have even asked yourself, what are the different types of bonds? Perhaps you’ve heard that you’re better off owning stocks because bonds earn a lower rate of return. But is that true?
Well, today, we’re going to put all of those questions to bed. This comprehensive guide to the types of bonds will help you learn about what bonds are, why you should consider investing in them, and what types of bonds might be right for you.
What Is a Bond?
In finance, the most common asset classes are stocks and bonds. While most people are familiar with investing in stocks, in this post, I want to focus on bonds.
To start, let’s cover the definition of a bond. A bond, in its simplest form, is a loan. Typically, corporations or the government will need to borrow money to fund projects, operating expenses, etc. So, they’ll create a bond that they’ll then sell to the public.
As an investor, you will give your money to the borrower, and in exchange for the use of your money, you will earn a fixed rate of interest in return. In other words, over the life of the bond, the issuer will return your initial investment plus interest.
Typically (though not always), the borrower will pay interest during the term of the bond, and then you will receive your principal back at the maturity (end of the term) of the bond.
You may have also heard people ask, “what is a fixed income investment?” Bonds are a form of fixed income investment! Why? Because they seek to preserve capital (your original investment) and produce a fixed amount of income in the way of interest.
Now that we’ve got that down, let’s talk about why people invest in bonds.
Why Do People Buy Bonds?
Most people have portfolios that consist of a mix of stocks and bonds. Generally, stocks produce higher returns, but they also carry a higher risk. Bonds, by comparison, produce relatively lower returns, but they also have a usually lower risk.
When we think about stocks, your upside is unlimited, but your potential downside is losing your initial investment.
However, with bonds, assuming the borrower is creditworthy and does not default on the bond (more on that in a minute), the issuer will repay your investment as principal plus a fixed amount of interest. That is, your principal is generally secure.
While bonds do have a lower upside, if your goal is to produce stable income, bonds can help you reach that goal.
While bonds can add stability to your portfolio, the reason I invest a small amount of my portfolio in bonds is that they can improve risk-adjusted returns. Let me say that again. Bonds can improve risk-adjusted returns.
Without getting into the nitty-gritty details of financial theory, the point is that having some bonds in your portfolio can increase returns while decreasing risk.
If you want to learn more about why bonds can improve portfolio returns, check out this article on the efficient frontier.
While the right mix of bonds for your portfolio depends on a host of factors like age, risk tolerance, etc., know there are many cases where they may make sense. I’d encourage you to check out this post on How to Start Investing: A Beginner’s Guide to learn more about the right bond allocation for your portfolio.
What are the Types of Bonds?
Now, let’s get into the three types of bonds that are most common.
The most common type of bond is the treasury bond. The federal government issues this type of bond. Treasury bonds are the safest type of bond because they’re backed by the United States government’s full faith and credit.
Said differently, most financial experts consider treasury bonds to be risk-free. While this is a bit of a misnomer (because the bond’s value can increase or decrease based on external factors like interest rates), it is essential to know that these bonds are as close to a risk-free investment as you can get.
One upside of treasury bonds is that they are exempt from state and local taxes.
While it is a nuance, you will hear people refer to these types of bonds as treasury bills, treasury notes, and treasury bonds.
Do not get confused by this terminology: these are all bonds. The only reason you may hear this different terminology is because of the varying duration of the bonds as follows:
Bills: Mature in 1 year or less
Notes: Mature in 1 to 10 years
Bonds: Mature within 10 to 30 years
Our second category of bonds is corporate bonds. Corporations issue these bonds to use for a wide variety of purposes.
Notably, corporate bonds typically carry a higher rate of return than treasury bonds. Why? Because they have more risk. You rely on the corporation to make good on their promise to pay you back rather than the federal government.
For example, consider buying a treasury bond and a bond issued by Apple. The treasury bond is less risky (because there is virtually no default risk) relative to Apple’s bond. The Apple bond, however, likely carries a higher interest coupon payment in exchange for this risk.
Corporate bonds are taxable at the federal, state, and local levels.
I want to break down further corporate bonds based on credit risk. When it comes to corporate bonds (and all bonds for that matter), it is crucial to understand the borrower’s underlying creditworthiness.
Let’s use the example of Apple again. If you compare two bonds, one from Apple and one from T-Mobile, which do you think is riskier? T-Mobile, of course! Why? Because Apple has probably the lowest probability of default of any corporation, T-Mobile is more likely to default on its obligation.
Bonds are assigned a credit rating, which is an indicator of default risk. Bonds with higher default risk will pay more in interest, but that’s because there is a higher likelihood of losing your investment.
You may hear the terms investment-grade bond and high-yield (or junk) bond. Investment-grade bonds typically carry a credit rating of BBB (on the S&P/Fitch scale) or Baa (on the Moody’s scale) and above.
Investment-grade bonds have lower default risk and will generally earn a lower return. Junk bonds, on the other hand, have a higher risk and will earn a higher return.
Note that the terms investment-grade and high-yield can apply to other types of bonds, such as municipal bonds.
The third main category of bonds is municipal bonds. These bonds are what they sound like: they are debt instruments issued by state and local governments.
Municipal bonds are considered riskier than treasury bonds because they rely on the state or city’s ability to pay back the investment. Notably, municipal bonds have not experienced frequent defaults, but there have been cases of default. Two notable examples were when Detroit and Puerto Rico defaulted on their obligations.
Municipal bonds are exempt from federal taxes, and in some cases, state and local taxes as well.
Municipal bonds typically come in two forms: general obligation bonds and revenue bonds.
General obligation (GO) bonds are typically not secured by any collateral and are backed by the issuer’s full faith and credit (i.e., the city or state). The power of these bonds is that the city or state can increase taxes to cover the obligations. Generally speaking, this means general obligation bonds are lower risk.
Revenue bonds, however, are secured by some form of revenue. For example, if a city issues a bond to build a toll road, that bond may be backed by revenue from the tolls. However, because the taxing authority does not back revenue bonds, they carry higher risk (and typically a higher interest rate) than general obligation bonds.
Other Types of Bonds
While treasury bonds, corporate bonds, and municipal bonds are the most common categories of bonds, there are many other types of bonds out there, which I want to cover briefly.
A zero-coupon bond is different than a typical bond because it does not make regular interest payments. You won’t receive any interest payments from this type of bond.
Instead, an investor buys a zero-coupon bond at a discount, and then at maturity, you will receive the par value of the bond. For example, you might purchase a zero-coupon bond for $90 and receive $100 when the bond matures.
For example, government zero-coupon bonds with short-term durations are typical.
Another category of bonds backed by Uncle Sam is savings bonds. Savings bonds come in a couple of different flavors: Series EE bonds and Series I bonds.
Series EE bonds are relatively cookie-cutter. They pay a fixed rate of interest and have a duration of up to 30 years. Check out this guide to Series EE savings bonds to learn more.
Series I savings bonds are a bit different. These bonds track the rate of inflation, making sure your real return is at least zero. In essence, these bonds pay the rate of inflation plus an additional fixed rate of return.
Government-related entities issue agency bonds. It is important to note that these bonds are not necessarily backed by the U.S. government’s full faith and credit. This lack of government backing means these bonds carry a somewhat higher default risk than treasury bonds.
Examples of these types of bonds include those issued by Fannie Mae and Freddie Mac.
You may have heard the term mortgage-backed security following the financial crisis. Real estate holdings such as residential homes serve as collateral for mortgage bonds.
These bonds are essentially a pool of mortgages bundled together and then sold off to the public markets in the form of debt.
TIPS, or Treasury inflation-protected securities, are bonds that help protect your investment from the risk of inflation. They work a little differently than Series I bonds because TIPS have regular adjustments to both principal and interest.
Separate Trading of Registered Interest and Principal of Securities, or STRIPS, are a form of a zero-coupon bond.
STRIPS allow investors to hold and trade individual interest and principal components of treasury notes and bonds as separate securities.
Without going into too much detail, you can visit the treasury website to learn more about STRIPS.
Finally, there is a whole world of international bonds available outside the U.S. I would note that I do not invest in any foreign bonds because you are also taking foreign exchange risks in addition to the regular risks associated with bonds.
I purchase bonds as the “safe” part of my portfolio, and I believe that international bonds add unnecessary risk.
What are the Risks of Bonds?
While bonds are generally lower risk than stocks, they come with risks you should understand before buying bonds.
1) Interest Rate Risk
Let’s say you purchase a bond that pays 3% interest, but interest rates rise after you buy it. If you were to buy a new bond today, maybe you could earn 4% interest. The bond that pays 3% is now worth less, pushing the price of the bond down.
Therefore, if you were to sell the bond before maturity in the secondary market, the 3% bond would be worth less (i.e., you would have to sell at a discount).
Note, however, if you hold the note to maturity, you will earn precisely the return expected when you purchased the bond.
2) Credit Risk
Perhaps the most substantial risk with bonds is you could lose your investment if the borrower defaults. For example, if you owned a corporate bond issued by Enron, you likely lost your investment when Enron went broke.
Credit risk is a consideration when buying any type of bond not backed by the U.S. federal government.
3) Inflation Risk
We previously covered that bonds produce a stable income. However, if there is inflation, your return may be worth less in real dollars.
For example, if your bond yields 4%, but inflation is 6%, your real return is -2%. Inflation makes the income from the bond less valuable.
4) Liquidity Risk
When you buy a bond, you are tying up your money for some fixed period. While this is generally okay, the only way out before maturity is to sell your bond in the secondary market.
Selling on the secondary market could mean:
A) You may have to sell at a discount (if the price of the bond has gone down).
B) There may not be a buyer for your bond. For example, if you own a bond of a company that is about to go bust, you may not be able to find a buyer for your bond to get out before they go broke.
5) Call Risk
Some bonds carry a call feature whereby the borrower can pay you off early. Think of this like refinancing a house. If interest rates go down, a borrower may pay you off to re-borrow at a lower rate.
When this happens, you may earn a lower return than anticipated because you don’t receive all of your expected interest payments, and you may not be able to find a replacement investment that earns a substantially similar rate of return.
6) Tax Treatment
While not a risk, per se, I do want to mention the tax treatment of bonds. Generally speaking, income from bonds is treated as ordinary income, meaning that you pay unfavorable amounts of tax on your earnings. Compare this to stocks, where the taxes on investment growth and sometimes dividends are at the capital gains rates (less).
Notably, some types of bonds, such as treasuries and municipals, carry more favorable tax treatment, so that is something to consider.
While bonds do carry risks, they can be a very worthwhile investment for your portfolio. I invest in bond funds rather than individual bonds. These funds hold hundreds (sometimes thousands) of individual bonds, increasing diversification and lowering credit risk.
While I won’t get into the nuances of bond funds today, I would encourage you to check them out.
Of note, if you can, I would encourage you to hold bonds in tax-advantaged accounts (such as an IRA, 401(k), etc.) because of the often-unfavorable tax treatment.
Types of Bonds: A Summary
While I know this has been a lot of ground to cover, hopefully, you now have a sense of the different types of bonds and the unique advantages and disadvantages of each.
While there are many types of bonds, you’ll find over time that a mix is likely right for your portfolio based on your risk tolerance and investment profile.
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