Heavily investing in stocks may not be an ideal strategy for many, so there are other options out there like investing in bonds. A bond portfolio can provide preservation of capital, a steady income stream, and offset some of the volatility that stocks might experience in any given cycle.
Bonds are a form of debt issued by governments and companies to fund operations, certain projects, or to just boost their cash position. For investors, bonds are a type of debt investment. In return for buying bonds, investors are promised repayment of investment at maturity, which is the end of the bond’s life. Bond maturities can vary from a few months to decades. The typical maturity for short-term bonds is one to three years, for intermediate-term bonds it’s four to ten, and for long-term it's ten to thirty.
Bonds enjoy a steady stream of income in the form of interest payments. Bond interest, called a coupon payment, is generally paid semi-annually. For most bonds, there are two key advantages over other investments like stocks:
Less risk. The issuer of the bond promises to repay the principal amount — also known as par value or face value — at maturity.
Steady stream of income. The issuer agrees to pay set interest payments based on the set rate (coupon rate) when the bond is issued.
While bonds are considered relatively safe, since bondholders must be paid before stockholders, there's still risk if the issuer fails or goes bankrupt. Thankfully, there are many different types of bonds to choose from.
Bonds can have varying maturities, which are the length of time before full repayment; coupon rates, also known as interest rates; and yields. Most bonds issued in the U.S. are government bonds, corporate bonds, agency bonds, and municipal bonds.
Government bonds. Government bonds are issued by the U.S. government and are classified as Treasurys. They tend to be the safest, having the lowest risk of default.
Corporate bonds. Companies issue these bonds and they usually have higher yields than the other types of bonds on the list. They’re riskier than government bonds in the event the issuer’s business declines and they cannot afford repayment.
Agency bonds. Federal government agencies or affiliated organizations issue agency bonds. These bonds are different from government bonds as they aren’t issued by actual governments, but agencies.
Municipal bonds. Local and state governments issue these bonds. Also known as muni bonds, they tend to offer the lowest yields of the four — but they also have key tax advantages, such as being tax-free on state and federal levels.
Government bonds, also known as Treasurys, are considered the safest possible bond investments because the U.S. government issues and backs these loans. Given their safety, they tend to offer the lowest yields, but are highly liquid, which means they’re easy to buy and sell.
There are four different types of bonds the U.S. government issues:
Savings bonds. Sold to individual investors directly from the Treasury.
Treasury notes. Treasurys with maturities between two years and ten years, most commonly ten years.
Treasury bonds. Treasurys with maturities of more than ten years, most commonly thirty years.
Treasury Inflation-Protected Securities (TIPS). The principal balance of the bond adjusts — unlike other Treasurys — to provide a return that’s meant to keep pace with inflation. Maturities for TIPS are five, ten, or thirty years.
Savings bonds are tailored for individual investors — available in lower increments to make them more accessible. It is important to note; however, that there are purchase limits for savings bonds and you can only buy or sell them via the Treasury. The Treasury issues two types of savings bonds — Series EE bonds and Series I bonds. Both types of bonds are exempt from state and local taxes, but are taxable at the federal level. Each has an initial maturity of twenty years and may be extended an additional ten years for a total thirty-year potential maturity.
Series EE bonds
Series EE bonds, also known as Patriot Bonds, will at least double in value within their initial twenty-year term. They pay a fixed interest rate via semi-annual coupon payments for the life of the loan. EE bonds have a maximum annual purchase limit of $10,000 per individual per calendar year.
Series I bonds
Series I bonds earn a fixed interest rate as well as a variable inflation rate. The purpose of these bonds is to protect investors against inflation. The variable inflation rate is adjusted semi-annually for inflation. These bonds are considered zero-coupon bonds, which means they don't pay interest payments. Instead, the interest increases the principal, which is the amount paid to investors at maturity. Individuals are limited to $10,000 per year in I bond purchases, plus an extra $5,000; however, the money for the $5,000 purchase must be from a tax refund.
Benefits of savings bonds
Savings bonds are backed by the U.S. government and can be bought in any increment from $25 to $10,000. EE bonds are guaranteed to double over a twenty-year period, while I bonds have no such guarantee. Inflation determines the total return for an I bond.
Note that all government-issued savings bonds require a 12-month lockup period. During this period, investors are prohibited from cashing in on their bonds. Additionally, if you cash in the bond within five years, you must forfeit three months of interest.
Treasury notes (T-notes) are U.S. government-issued bonds that have a maturity between two and ten years — typical maturities for T-notes are two, three, five, seven, and ten years. Note that Treasurys with maturities of one year or less are called Treasury bills (T-bills).
T-notes pay fixed semi-annual coupon payments and are available for purchase in increments of $100. Treasury notes, unlike savings bonds, are marketable securities, meaning they can trade on the secondary market.
Benefits of Treasury Notes
T-notes are useful for investors looking for the safest possible option for storing cash in the near-term. Risk-averse investors that need their money in a few years, such as those looking to make a major purchase, may consider investing in T-notes.
Treasury bonds are longer-term government bonds, having maturities of over ten years. The two terms the Treasury offers for T-bonds are twenty and thirty years. Like T-notes, T-bonds pay semi-annual fixed interest payments and are available in increments of $100, starting at just $100. They're also just as liquid given their ability to trade on the secondary market.
Benefits of Treasury Bonds
T-bonds are useful for young investors looking to store cash for a long time, but needing a steady return. T-bonds are also useful for investors who prioritize preservation of capital, such as those in or approaching retirement. Investors can lock in their savings for twenty or thirty years and get semi-annual interest payments while getting the closest thing to a guaranteed return of invested money possible.
Treasury Inflation-Protected Securities (TIPS) are Treasury securities that are meant to help investors fight off inflation. However, they're different from Series I bonds. TIPS have greater liquidity, given they trade on secondary markets. They can have maturities of five, ten, or thirty years.
Unlike Series I bonds, where the interest rate changes, the face value of TIPS changes to account for inflation. As inflation rises, the principal amount increases.
Benefit of TIPS
TIPS also pays a semi-annual interest payment. The interest payment is based on the principal amount — as inflation rises, the principal also rises, pushing coupon payments higher. TIPS also have higher purchase limits than I bonds. Investors can purchase up to $10 million directly from the Treasury.
Companies often utilize the bond markets for capital because the coupon on a corporate bond is typically lower than an interest rate for a bank loan. Corporate bonds often enjoy more favorable terms for the issuer than traditional bank loans. With greater flexibility and a typically higher default rate, corporate bonds tend to offer higher yields than government bonds.
The “safety” of corporate bonds can vary based on the credit risk of the issuer. Corporate bonds are typically grouped into two categories: investment grade and non-investment grade. Investment-grade corporate bonds are ones that are assigned a favorable credit score from rating agencies. Non-investment grade bonds, also known as junk or high-yield, have lower credit ratings.
Corporate bonds tend to be fairly liquid and less volatile than stocks. Even if a company fails, its bondholders will be repaid before stockholders.
Investors tend to turn to corporate bonds when looking for higher yields, great liquidity and a variety of options, such as various maturities and risk levels. Investors can better customize their investments to a specific maturity and riskiness than with government bonds. One key difference, however, is that interest from these types of bonds is subject to both federal and state taxes. They also have higher minimum investment amounts, such as $5,000.
Agency bonds are akin to municipal bonds, except U.S. government agencies or government-sponsored enterprises issue them, such as Fannie Mae and Freddie Mac. The U.S. government guarantees many agency bonds, making them very comparable to government bonds.
Even with the implied backing of the U.S. government, most agency bonds offer yields higher than Treasurys. Granted, these types of bonds are slightly more risky, but still offer semi-annual interest payments. The minimum investment for agency bonds is generally much higher than you’d find with Treasurys. Unlike Treasurys, agency bonds tend to be taxable on both the state and federal levels. Although there are some agency bonds that are exempt from both.
Municipal bonds, also known as muni bonds or munis, are bonds issued by local and state governments. Municipalities issue debt to fund projects or to finance operations. These bonds are relatively safe, but not as safe as Treasurys. Municipalities can default or go bankrupt, such as Detroit’s bankruptcy in 2013. Granted, it’s much less common than corporate bankruptcies.
The biggest benefit of muni bonds is that they’re exempt from federal income taxes, but they also tend to be exempt from state taxes in the state where they are issued. Given the tax treatment, some municipal bonds trade with yields that are lower than Treasurys.
Many investors — especially those in higher income tax brackets — will look to buy municipal bonds issued in their home state. By doing so, investors can avoid both federal and state income taxes. For example, if an investor lives in New York and buys a bond issued in that state, they generally don't have to pay federal or state taxes on income from that bond. Some bonds are even triple tax-exempt, meaning they're exempt from federal, state, and local taxes. For example, a resident of New York City that buys munis issued by NYC is likely to avoid paying federal, state, and local taxes for that bond.
Municipal bonds are also advantageous to investors in states that aggressively tax income, such as California. But investors in lower tax brackets may be giving up return potential by investing in munis. Investors living in states with low or no state income taxes also look to municipal bonds of other states. Especially if they offer higher yields than other in-state munis or other options like agency bonds.
Note that municipal bonds typically have a higher minimum purchase and liquidity for certain issuances may be limited.
There are also other key types of bonds, namely junk and international bonds. These bonds can be useful for investors looking for higher yields or additional diversification.
Junk bonds, also known as high-yield bonds, are corporate bonds with lower credit ratings. Thus, junk bonds have a higher risk of default compared with many government and corporate bonds. As a result, junk bonds tend to offer higher interest rates — hence, the name high-yield bonds.
A credit rating agency may rate a corporate bond low for various reasons. For example, if the issuing company has cash flow issues or high debt levels, its bond may be rated non-investment grade. Investors with a greater risk appetite, but looking for returns that are superior to dividend yields may consider junk bonds.
International bonds are generally any bond issued by governments outside the U.S. These bonds can be useful for investors looking for fixed income investments overseas. Some bonds issued by overseas governments offer superior yields to Treasurys, but still have the backing of the central government there.
For example, the yields for ten-year bonds issued by New Zealand, Italy, and Australia offer higher yields. Emerging market international bonds can offer yields that rival junk bonds. Still, investors must assess the risk the country will default on these bonds, and consider political and economic stability.
Bond funds and bond exchange traded funds (ETFs) give investors the ability to get exposure to various types of bonds by buying just one security. Buying either of these types of investments gives you a stake in a basket of bonds. Investors looking to diversify with bonds often turn to bond funds or bond ETFs.
For example, a bond ETF may offer exposure to Treasurys, agency and municipal bonds, as well as corporate bonds — with the purchase of just a single security. The minimum investment for these securities is often lower than the minimum purchase if you were to buy bonds directly from the issuer or via a brokerage. Generally, there's no holding period requirement either.
The beauty of bonds is that they help offset exposure to more volatile stock investments. Most investors should build a portfolio that includes both stocks and bonds, helping diversify against market volatility.
Trying to decide just how bonds can improve your portfolio and the types of bonds that might suit you? FinanceHQ is here to help connect you with a financial advisor who can create a tailored investment strategy that suits your needs.
Marshall Hargrave is a former SEC-registered investment adviser who is now a strategy consultant for fintech companies.