Types of bonds: Advantages and limitations
Bonds are often cited as a core holding in retirement portfolios — and for good reason. Bonds can help generate income for investors and are typically less volatile than stocks, but there are many different types of bonds investors should be aware of, and each type has some special considerations investors should watch out for.
Here are the key types of bonds and their advantages and disadvantages.
What is a bond?
A bond is a form of debt where the bond issuer borrows money in return for paying interest and returning the bond’s principal to the buyer when the bond matures. Bonds are commonly issued by governments and businesses to fund their operations or special projects.
Investors like bonds for their income-generating potential and lower volatility compared to more risky investments such as stocks. Bonds are often included in investment portfolios because of their diversification benefits and income generation, helping to smooth a portfolio’s returns.
Types of bonds: Advantages and disadvantages
Bonds are divided into a few major groups depending on the issuer: the U.S. Treasury, a corporation, a state or local government, a foreign government or a U.S. federal agency.
U.S. Treasurys
Treasury bonds are issued by the U.S. federal government and are considered one of the safest investments you can make. The debt is backed by the “full faith and credit of the United States” and the government has never defaulted on its bonds, so the investment is considered low risk.
This fact doesn’t mean investors can’t lose money investing in Treasury bonds, however. Bond prices and interest rates move in opposite directions, so when prevailing interest rates rise, bond prices fall. In recent decades, Treasurys have often traded at low yields, making it difficult for bondholders to keep up with inflation.
- Advantages: Safety and low risk, thanks to backing of U.S. government
- Disadvantages: Limited growth potential and prices will fall if interest rates rise
Corporate bonds
Corporate bonds are issued by businesses as a way to fund their operations or various capital spending needs. Corporate bonds aren’t backed by the government, so they aren’t as safe as Treasurys, but that means they’ll typically offer higher yields. The interest rate available will depend on the financial strength of the company doing the borrowing.
Corporate bonds are often divided into two categories:
- Investment-grade bonds
- Investment-grade bonds come with at least a BBB- rating (or Baa3 from Moody’s) from credit rating agencies. These bonds are believed to have lower credit risk than their high-yield counterparts and therefore offer lower yields, all else equal.
- High-yield bonds
- Sometimes referred to as junk bonds, high-yield bonds offer higher interest rates to investors because they are considered greater credit risks than investment-grade bonds. High-yield bonds sometimes trade more like stocks due to the higher risk involved, meaning they may be more volatile.
- Advantages: Potential for higher returns than Treasury bonds
- Disadvantages: Greater risk than Treasurys, particularly for high-yield bonds
Municipal bonds
Municipal bonds, or munis, are issued by state and local governments and are often used to fund projects such as road construction or schools. The nice thing about municipal bonds is that they’re typically exempt from federal taxes and you may avoid state and local taxes as well. For this reason, municipal bonds are typically issued and trade at lower yields, but you can calculate a tax-equivalent yield by adjusting for the tax savings.
Since municipal bonds come with tax benefits, it doesn’t make sense to hold them in tax-advantaged accounts such as an IRA. It’s best to hold municipal bonds in a taxable brokerage account.
Investors in high tax brackets benefit the most from municipal bonds, but other investors may also find them suitable for their portfolios. These municipal bond funds are some of the best ways to include munis in your portfolio.
- Advantages: Tax-free yields and relative safety
- Disadvantages: Benefit high-income investors the most
International government bonds
International government bonds are issued by foreign governments and come with some unique risk factors that investors should consider. Depending on the country issuing the debt, investors may need to watch for political instability, currency risk or other risks. Unlike the U.S. government, some other foreign governments have defaulted on their bonds from time to time, so investors shouldn’t consider these to be safe in the same way they would Treasurys.
- Advantages: Potential for higher yields and currency gains
- Disadvantages: Higher risk due to political issues, currency depreciation and default
Agency bonds
Agency bonds are issued by government-sponsored enterprises or federal agencies. These bonds don’t have the direct backing of the U.S. government, but they’re still quite safe because of their government association. Key government-sponsored enterprises include Fannie Mae and Freddie Mac, both of which help maintain the health of the U.S. mortgage market.
Agency bonds typically offer slightly higher yields than Treasurys, making them a low-risk way to get some extra return in your portfolio.
- Advantages: Higher return than Treasurys, overall safety
- Disadvantages: Not directly backed by the U.S. government
Bottom line
Bonds are a staple of most investors’ portfolios, but it’s important to be aware of the different types. Make sure you understand the risks associated with different bonds and what they offer you as an investor. Some bonds are built for safety, while others provide more in the way of return in exchange for higher risk. Also, take into consideration your individual risk tolerance and time horizon.
