7 Types of Bonds You Should Know About
Learn what bonds are, how they generate income for investors, and the different types of bonds to invest in. Plus, discover their pros and cons.
Stocks, cash, and bonds are the three fundamental asset classes in investing. While all three play a significant role in your investment portfolio, bonds often act as the balancing act in this financial trinity.
In this guide, we’ll review the ins and outs of bonds (sometimes called debt securities), including what they are, how they work, and the seven types of bonds available. We’ll also discuss the benefits and drawbacks associated with bonds.
What is a bond?
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower, typically a corporation or government. The borrower agrees to repay the borrowed money, called the principal, at a specified date (or the maturity date). Until that date, the borrower also pays the investor periodic interest payments, usually at a fixed rate.
How do bonds work?
Bonds represent debt securities issued by governments, municipalities, or corporations. Understanding how bonds work involves unraveling various aspects, from issuance to yield:
Issuance
The bond issuance process starts when an entity needs to raise funds. It issues bonds, effectively borrowing money from investors. Each bond has specific terms, including the interest rate, maturity date, and the amount to be paid back.
Principal/par value
Each bond has a face value called the principal or par value. This represents the amount the issuer promises to repay the bondholder at the bond's maturity date. It serves as the baseline value for the bond.
Coupon payments
Bonds make periodic interest payments to investors, known as coupon payments. These payments are based on either a fixed or floating interest rate, providing a source of fixed income for bondholders throughout the bond's life.
Maturity
Maturity refers to when the bond's principal is repaid to investors. Bonds can have various maturity lengths––from short term (a few years) to long term (up to 30 years or more). At maturity, the issuer repays the principal, and the bond's contractual obligations conclude.
Market value
While a bond’s principal is fixed, its market value can fluctuate. This is influenced by factors like changes in interest rates, the creditworthiness of the issuer, and market demand. If interest rates rise, bond prices typically fall, and vice versa. Investors can buy or sell bonds on the secondary market, potentially at prices different from the par value.
Yield
The yield is the return an investor gets on their bond investment. It factors in the coupon payments and the price paid for the bond. If a bond is bought at a discount (below par value), the yield will be higher than the coupon rate. Conversely, if bought at a premium (above par value), the yield will be lower.
How do bonds generate income for investors?
Bonds typically generate income through fixed-rate interest payments. And this involves a balancing act between the factors mentioned above.
For example, if an investor purchases a bond at a discount, their yield to maturity will be higher than the bond's coupon rate because they're set to receive more at maturity than they paid. However, if interest rates rise, the bond’s market value may decrease, but the yield to maturity for a new investor buying at that lower price will be higher.
Where to buy bonds
Several avenues exist for investors looking to add bonds to their portfolios. Each method offers its own features and benefits, and the choice largely depends on the investor's individual needs, investment strategy, and level of expertise.
Here are a few options available:
Exchange-traded funds (ETFs)
Bond ETFs are a convenient way to invest in bonds through a stock exchange. These offer liquidity, diversification, transparency, and the ability to target a specific corner of the bond market.
For example, bond ETFs may track specific bond indices or focus on particular sectors, such as corporate bonds, munis, or government bonds.
(For those interested in bond ETF strategies, Composer offers innovative tools to create and manage such portfolios effectively.)
Brokerage firms
Brokerage platforms are another common way to purchase bonds. Investors can access various bond options and maturities through their brokerage accounts. These platforms provide research tools and resources to help investors make informed decisions.
TreasuryDirect
For those looking to invest in the U.S. government’s treasury bonds, the TreasuryDirect website allows investors to buy bonds directly from the government. This eliminates the need for intermediaries and provides a secure and straightforward way to own government debt.
Mutual funds
Mutual funds offer a professionally managed approach to bond investing. Bond mutual funds pool investors' money to purchase a diversified portfolio of bonds. Fund managers then make active investment decisions based on the fund's objectives.
Online platforms
Numerous online investment platforms and apps provide access to various bonds and bond funds. These platforms offer user-friendly interfaces, research tools, and educational resources, making it easier for investors to explore bond investment options.
Financial advisors
Investors seeking more personalized bond investment strategies can use a financial advisor. These professionals assess investors’ goals, risk tolerance, and time horizon to recommend suitable bonds or bond funds.
Directly from issuers
In some cases, investors can purchase bonds directly from issuers. This is common with municipal bonds, where local governments issue bonds to finance public projects. Buying directly from issuers eliminates intermediaries and may provide tax advantages.
7 types of bonds to invest in
Bonds come in various types, each with characteristics, risks, and benefits. Understanding these is crucial for investors to diversify their portfolios and choose options that align with their investment goals and risk tolerance. Here are seven key types:
Government bonds
1. Treasury bonds
These are issued by the U.S. Department of the Treasury and backed by the government's faith and credit. Treasury bonds are considered low-risk investments and provide fixed-rate interest payments.
2. Treasury inflation-protected securities (TIPS)
TIPS shield investors from inflation. Their principal value adjusts with changes in the consumer price index (CPI), ensuring investments keep pace with rising prices.
3. Government National Mortgage Association (GMNA) bonds
Ginnie Mae is a government agency under the U.S. Department of Housing and Urban Development (HUD) that guarantees mortgage securities backed by federal agencies like the Federal Housing Administration (FHA) and Veterans Affairs (VA). GNMA bonds are highly secure, making them ideal for risk-averse investors.
Corporate bonds
4. Investment-grade corporate bonds
These bonds are issued by financially stable corporations with strong credit ratings. They provide regular interest payments to investors and are generally considered lower risk.
5. High-yield bonds (junk bonds)
High-yield bonds are issued by companies with low credit ratings, which means they carry a higher level of risk. However, they also offer the potential for higher returns.
Municipal bonds
6. General obligation bonds
Municipalities issue general obligation bonds (often called munis), backed by their full faith and credit, often supported by taxes. The funds raised through these bonds are used for various public projects, such as roads, bridges, and educational facilities.
7. Revenue bonds
Also issued by municipalities, revenue bonds are backed by the revenue generated from a specific project or source, such as toll roads, utilities, or other income-producing assets. These are riskier than general obligation bonds but offer higher yields.
Pros and cons of investing in bonds
Like any investment, bonds have their unique pros and cons, and understanding these can help investors make informed decisions that align with their financial goals and risk tolerance.
Here are a few pros and cons:
Pros
Diversification: Including bonds in a portfolio helps diversify investments, reducing overall portfolio risk. Bonds often have a low correlation with stocks, so when stocks are volatile, bonds can provide stability.
Income stability: Bonds typically provide a steady income stream through regular interest payments. This predictability especially appeals to those seeking a consistent return, such as retirees.
Capital preservation: Bonds can be an effective way to preserve capital, especially if held to maturity. They are ideal for risk-averse investors who want to protect their principal investment.
Lower risk than stocks: Generally, bonds are considered less risky than stocks. Government and high-grade corporate bonds, in particular, offer lower default risk, making them a safer investment choice.
Cons
Low returns: Bonds are sensitive to changes in interest rates. When interest rates rise, bond prices typically fall, potentially resulting in capital losses for bondholders.
Credit or default risk: While government bonds are often considered very safe, corporate bonds can carry the risk of default, meaning the issuer can’t make interest payments or repay the principal. This risk is higher with lower-rated bonds.
Inflation risk: Fixed interest payments from bonds may not keep up with inflation, potentially eroding the purchasing power of the income over time, especially with long-term bonds.
Interest rate risk: When interest rates rise, bond prices typically fall. This makes bonds, especially those with longer maturities, susceptible to losses if sold before maturity in a rising interest rate environment.
Confidently invest in bonds ETFs with Composer
When it comes to bonds, Composer is your trusted companion, helping you explore bond ETFs, access in-depth research, and make informed investment decisions.
Whether into government bonds, corporate bonds, or munis, Composer provides all you need to build a diversified portfolio that aligns with your financial goals.