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Have you ever found yourself with 100% stocks in your portfolio?
Many investors tend to forget that the bond market offers such a wide range of possibilities that it would be a shame not to include this asset type in their portfolio.
However, an investor should know the different types of bonds in detail in order to make successful moves.
There are many different types of securities depending on the issuer – government, municipal, corporate as well their maturity, yields and many other factors.
So what is the best strategy?
Your strategy, goals and risk management should determine what kind of bonds you would like to include in your portfolio. In this article, we will be looking at the ten most common types of bonds.
What is a Bond?
When governments and enterprises need to raise funds, they issue bonds. You're giving the issuer a loan when you buy a bond, and they pledge to pay you back the face value of the loan on a particular date, as well as periodic interest payments, usually twice a year.
Unlike stocks, bonds issued by firms provide you no ownership rights. So you don't necessarily gain from the firm's development, but you also won't notice much of a difference if the company isn't doing so well—as long as it has the wherewithal to keep its loans current.
Bonds, on the other hand, can provide you with two potential benefits if you include them in your portfolio: They provide a steady stream of income while also mitigating some of the risk associated with stock ownership.
You can simply receive interest payments on a bond while waiting for it to mature—the day on which the issuer has pledged to repay the bond's face value.
The secondary market, on the other hand, is where you can purchase and sell bonds. Bonds' value will fluctuate like a stock's when they are first issued. If you hold the bond until it matures, the swings won't affect your interest payments or face value.
When buying and selling bonds, however, keep in mind that the price you pay or get is no longer the bond's face value. When it comes to bond selection, the bond's susceptibility to value changes is crucial.
1. U.S. Treasury Bills, Bonds, And Notes
Treasury bills, bonds, and notes are tradable, fixed-income debt securities issued by the US Treasury Department. Practically, they all are types of bonds.
In addition, they are secured by the US government which makes them one of the safest investments on the market. Another benefit is that investors shouldn't pay state income taxes on the interest.
On the other hand, they are one of the weakest performers when it comes to profit. Almost all investors have them in their portfolio because they are safe and predictable.
So what is the difference between them
The major difference between the three types is their maturity. Treasury bills are short-term securities issued for a year or less. Treasury notes maturity is 2,3,5 and 10 years. Also, treasury bonds are obligations for a term of 30 years.
2. Other US Government Bonds
Not all government bonds are issued by the Treasury Department, some of them are released by government agencies, such as Fannie Mae (the Federal National Mortgage Association) and Ginnie Mae (the Government National Mortgage Association).
These bonds offer higher yields than the US treasury bonds and also carry relatively low risk.
On the downside, they are not exempt from state and federal income taxes.
Savings bonds are one of the safest investments, but over time investors have become a little more confident about taking on riskier investments, as you can see from this chart using FED Survey of Consumer Finances data
3. Municipal Bonds
Municipal bonds (also known as “munis”) are securities issued by municipalities or local governments to fund specific expenditures, such as the construction of highways, bridges or any other specific projects.
One of the biggest benefits to investors is that the interest munis generate is tax-free on a federal level. What's more, if the investor lives in the state where the bonds have been issued, they also do not owe state taxes.
This is the reason why they offer lower yields and returns than taxable bonds.
Some of the types of municipal bonds are general obligation bonds, revenue bonds, anticipation notes, insured municipal bonds and others.
4. Corporate Bonds
Now you’re ready for a bit riskier (and profitable) bonds.
When we talk about companies, we usually discuss stocks. However, corporations can also issue fixed-income securities called corporate bonds.
Businesses should be careful with the debt they issue since it could damage both their short-term and long-term profits. Regarding their maturity, corporate bonds are classified as follows:
- Short-term bonds – with a five-year term or less
- Intermediate bonds – with maturity between 5 to 12 years
- Long-term bonds – more than 12 years
Since companies are much more volatile and riskier than governments, the bonds they issue are riskier than government securities. On the other hand, this promises higher returns.
There are many different corporate bonds variations: straight cash bonds, split-coupon bonds, pay-in-kind (PIK) bonds, floating-rate and increasing-rate notes, deferred-interest bonds, convertible bonds (which are discussed later in the article) and multi-tranche bonds.
5. Foreign Bonds
A foreign bond as per Investopedia definition is “ a bond issued in a domestic market by a foreign entity in the domestic market's currency”. The two main characteristics are that the bond is traded on a foreign financial market and is denominated in a foreign currency.
The purpose of investing in foreign bonds is to diversify your portfolio as much as possible and gain interest in different currencies.
However, there is a high currency risk which depends on exchange rates, and we know how volatile and unstable they are.
For example, an investor has purchased Japanese bonds with a 5-year maturity at an exchange level of 1 Japanese yen to 0.009 US dollar, meaning the person paid 0.009 per bond.
The time for the bonds to mature comes and the rate is 1 Japanese Yen to 0.007 US dollar, which means that he will receive only 0.007 per bond.
6. Convertible Bonds
As already mentioned, convertible bonds (also referred to as Cvs) are a type of corporate bonds that the holder can convert at any time to shares of the company issuer of the debt. The number of shares is predetermined.
To investors, this type of securities is quite attractive since it offers higher yields than government bonds or common stock and at the same time carries a stock option for the holder.
For this reason, however, they offer lower interest rates than the other corporate bonds.
Companies normally issue CVs in order to avoid negative market interpretation and reactions which might cause damage to their share prices. For instance, company X decides to issue stock.
The market, however, might see this as a sign of overvalued share price. Therefore, the company will issue convertibles to avoid this and later investors may convert them into stock.
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7. Non-Conventional Bonds
To understand non-conventional bonds, we have to explain what a conventional one is – their value, interest payment frequency, interest rate, and maturity date are fixed and specified.
Non-conventional ones, on the other hand, have rates and maturity which may vary and change with time.
Zero-coupon bonds (aka zeros), which does not pay coupons, is the most common type of non-conventional bonds. The most common issuers are governments and corporations.
Zeros are often sold at discount but as its name suggests they do not pay any coupon. Instead, investors receive all the interest at once when they mature.
A serious drawback is a fact that you have to pay taxes o returns even though you don't receive them annually. In addition, this type of bonds is more volatile and riskier than the other ones.
Even though governments and companies issue those bonds, you need to buy “strips” form a broker or a financial institution which has the right to sell them.
8. Preferred Stocks
The name is confusing, I know. These are stocks but they also share some things in common with bonds. For example, just like common stocks, they pay regular dividends. But, similarly to bonds, this dividend is predetermined and fixed.
On the downside, preferred stockholders have no ownership in the company and cannot vote for the board of directors. In case of bankruptcy, preferred stockholders first receive their money for their stocks whose price is preliminary determined.
9. Adjustment Bonds
These are types of securities issued by a company due to the process of recapitalization or restructuring. The outstanding debt of the corporation is transferred to the adjustment bonds and they are given to bondholders. This is required because the company wants to change the terms of its obligations in order to be able to escape default. Adjustment bonds pay interest only when the company generates earnings
When a company files bankruptcy under Chapter 11, they ask their creditors for protection in order to make payments on their obligations. Creditors will spread among themselves the company's value and liquidate it, but it won't be the full amount of the loans. The corporation and the creditors will work together to recapitalize the company so that they will not go bankrupt and continue to make payments on their loans. Logically, the value the creditors receive will increase.
10. Junk Bonds
Junk bonds (also high-yield bonds or speculative bonds) are corporate bonds with the lowest rating possible. Their names suggest that they are high-risk and high-return assets, offering several times higher interest rates than government bonds.
Even though they are a great investment option, you should approach them with caution. Indeed, they offer higher yields than other bonds and are less volatile than stocks.
According to the two biggest credit rating agencies Moody's and Standard and Poor's, these bonds are speculative. This, on the other hand, is a serious warning. It means that the company issuer is unstable and fiscally unsound. Be really careful with junk bonds.
How Credit Ratings Affect Bonds?
Most corporate bond issuers are assessed by the major rating agencies for their ability and willingness to pay interest and repay principal on time. These agencies analyze an issuer's creditworthiness using quantitative methods and qualitative judgments, and have devised a grading system to provide credit ratings to these issuers.
Only the largest and most powerful firms' bonds are usually eligible for the coveted “investment-grade” ratings, which reflect exceptional relative creditworthiness. Triple-A is the highest quality rating.
As the risk of default increases, the rating levels decline to triple-C, and finally to D, or default. Bonds rated Baa3 or above by Moody's, or BBB- or higher by Standard & Poor's and Fitch Ratings, are considered “investment grade” and have a low risk of default.
Companies with a Baa3 or BBB- rating are termed “speculative grade.” They are classed as high-yield bonds, as are several types of non-rated bonds, because they have a higher chance of default. The ratings for both investment-grade and below-investment-grade debt are listed in the table below.
Bottom Line
All in all, there are many different types of bonds on the market. On the whole, this asset class offers diversification of an investor's portfolio as well some tax benefits. Depending on your goals and what you want to achieve, you can pick up the right ones.
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