For many investors, the stock market is likely their first exposure to the world of investing. But did you know that the fixed-income market is actually bigger?
According to the Securities Industry and Financial Markets Association (SIFMA), the U.S. fixed-income market issued $10.1 trillion worth of securities in 2022 alone. Comparatively, the U.S. stock market issued just $81.9 billion.
Fixed-income assets are also known as bonds. They come in many forms, including U.S. Treasurys, investment-grade corporate bonds, high-yield junk bonds, mortgage-backed securities (MBS) and municipal bonds.
Investing in bonds can be a great way to complement an equity strategy and can help reduce volatility or improve income potential. This guide will help you understand the types of bonds available.
Types of Bonds
All bonds can be envisioned as a loan from you, the investor, to the issuer for a specified period of time. In exchange for your initial loan, the issuer will usually pay you interest on a semi-annual basis, called a coupon. When the bond matures, you receive your initial investment — the principal — back.
Bonds can be distinguished by several characteristics that are not mutually exclusive. Examples include:
- Issuer: This refers to the type of organization that issued the bond in the first place. Bond issuers can be government entities or corporations, which can be further separated into hierarchies like federal, state and municipal.
- Credit quality: This is a rating by a credit rating agency like Moody's, Standard & Poors (S&P) or Fitch that describes the risk of the bond issuer defaulting. Bonds with lower credit ratings tend to pay a higher interest rate to compensate.
- Maturity: This describes the length of time until your principal investment in the bond is paid back. Generally, the longer this is, the higher your interest rate will be. A closely related concept is duration, which describes the sensitivity of bond prices to interest rates. All else being equal, a bond with a longer maturity will have a higher duration and greater sensitivity to interest rate changes.
1. U.S. Treasurys
U.S. Treasurys are issued by the federal government. As an investment, they're considered very low risk when it comes to default. Treasurys come in three main types: bills, notes and bonds. The difference between the three is based on their maturity.
The safest option and the basis for the "risk-free rate" are Treasury bills, which can range in maturity from four weeks to 52 weeks. Treasury notes are considered an intermediate option and range from two years to 10 years. Finally, Treasury bonds are the longest option with a maturity of 30 years so they tend to be the most sensitive to interest rate changes.
Treasurys are commonly used by investors looking for a hedge against equity risk and are considered a flight-to-safety asset. Historically, they have soared in crashes like the 2008 Great Recession and the 2020 COVID-19 crash as investors looked for quality assets.
Other types of Treasurys include Separate Trading of Registered Interest and Principal of Securities (STRIPS), Treasury Inflation-Protected Securities (TIPS) and Series I Savings Bonds (I bonds). These types of Treasurys offer ultra-long maturities (in the case of STRIPS) and potential inflation protection (in the case of TIPS and I bonds).
2. Municipal Bonds
Municipal bonds are loans issued by governments other than Federal entities. This can include state, county and city governments. These entities use municipal bonds to raise capital to fund public infrastructure projects such as parks, bridges and waterworks.
Some investors prefer municipal bonds because of their tax-efficient structure. Unlike other bonds, the interest payments from municipal bonds are often exempt from federal taxation and can be exempt from state taxation depending on the investor's residency.
3. Corporate bonds
Corporate bonds are issued by private or publicly traded companies. Corporations issue bonds to raise funding without resorting to selling equity, which can dilute shareholder value. By buying a corporate bond, investors are essentially lending money to the corporation to be repaid with periodic interest.
Because corporations have a greater risk of bankruptcy compared to government entities, their bonds generally have a higher default risk and, as a result, lower credit ratings. To make up for this, corporate bonds usually pay higher interest rates compared to Treasury bonds of equivalent maturity.
Corporate bonds can also come in various forms. The most common is the investment-grade corporate bond, which has a credit rating of BBB or higher. These are generally considered safer as an investment, with a relatively low risk of default.
Corporate bonds with credit ratings lower than BBB are called high-yield or junk bonds. These bonds have much greater credit risk as there's a chance that their issuer cannot repay the interest or principal on time or in full. But they make up for it with a higher interest rate.
4. Mortgage-Backed Securities
When an individual purchases a home, they often take out a mortgage. By doing so, they must pay down the mortgage periodically, usually on a monthly basis. This creates a consistent stream of cash flows. Banks can then take that mortgage, wrap it up with many others and sell the resulting bond as a mortgage-backed security, which pays investors regular interest like most bonds.
Mortgage-backed securities that contained mortgages of poor credit quality were one of the key contributors toward the 2008 Great Recession. Investors who buy a mortgage-backed security should carefully examine the credit quality of the underlying mortgages. They are also more exposed to fluctuations in real estate prices than other types of bonds.
5. International bonds
From a U.S. investor's perspective, the term international refers to any market outside of the domestic market. This includes developed markets like Canada, France, Germany, the U.K., Japan and Australia and emerging markets like Russia, China or Brazil.
Investing in the bonds of international issuers can potentially provide diversification benefits and higher yields. Because interest rate changes can differ between countries, buying international bonds can hedge against declines in the U.S. bond market.
Just like the U.S. market, investors can buy both international corporate and government bonds. For the latter, it's important to note that many international governments do not have the same credit rating as the U.S. government so their government bonds may have a higher risk.
This is especially so for emerging market bonds. If these countries are suffering from political or economic instability, their government bonds might post a higher risk of default. Foreign bond investors should perform detailed credit-risk analysis and not chase high yields.
6. Green bonds
Green bonds are issued to finance an environmental, sustainability or climate-focused project. For example, a state that launches a tree-planting initiative might issue a bond to raise funds from investors. Green bonds can be issued by governments or corporations and have a variety of maturities and credit ratings.
Investing in green bonds can be ideal for investors who value environmental, social and governance (ESG) considerations. Sometimes, investing in green bonds can also provide certain incentives when it comes to taxation.
Benefits of Investing in Bonds
Bonds form an integral part of a diversified investment portfolio. As a complement to stocks, an allocation to bonds can provide many benefits, including:
- Lower volatility: An allocation to high-quality investment-grade or Treasury bonds can help investors minimize portfolio fluctuations and unrealized losses during bear markets or crashes.
- Higher income: Investment-grade corporate bonds can provide competitive yields on par or higher than dividend-paying stocks or real estate investment trusts (REITs).
- Inflation protection: TIPS and I bonds can help shield an investor's portfolio from the negative impacts of a sudden increase in inflation.
Drawbacks of Investing in Bonds
As with most things in investing, there isn't a free lunch when it comes to investing in bonds. While bonds provide many benefits, they can also pose certain risks, including:
- Lower returns: Investing in stocks exposes you to the equity risk premium, which is why as a whole, stocks tend to provide higher returns than bonds.
- Interest rate risk: Bond prices are inversely related to interest rate changes. When rates go up, existing bond prices drop so their yields become competitive with newly issued bonds.
- Credit risk: During an economic crisis, bonds with higher credit risk tend to fall as the creditworthiness of their issuers gets called into question.
Compare Bond Brokers
Bonds can be researched and compared via various platforms. Investors looking for further insights and reviews of bonds can use Benzinga to compare the available options for buying bonds. Here is a list of brokers that support bond purchases:
Frequently Asked Questions
Are bonds a good investment?
Whether bonds are a good investment depends on your investment objectives, time horizon and risk tolerance. For low-risk retired investors seeking consistent, safer income, an allocation to investment-grade corporate bonds and Treasurys might make sense. Investors willing to accept interest rate risk might prefer long-term Treasurys as a hedge against stock market crashes. Passive investors might default to holding a low-cost, aggregate bond exchange-traded fund (ETF) as a way of “buying the market.”
Should investors layer bond purchases?
Layering bond purchases is also known as bond laddering. This is done by buying bonds of staggered maturities. For example, an investor might buy a portfolio of five bonds, each maturing in consecutive years. Every year, the investor receives semi-annual coupon payments from all five bonds, and at the end of the year, receives the principal from the bond that matures. Bond laddering is a good way of diversifying bond allocations, as you are spreading risk between multiple issues and maturities and can create consistent cash flows.