Types of Bonds

If you’re an investor who wants to diversify your portfolio with bonds, it’s first important to understand that bond investing isn’t for everyone. Even though these common fixed-income instruments are known for their safety as well as simplicity, choosing which types of bonds to invest in can be quite confusing if you don’t have the right fundamental knowledge about how they’re issued.

So, before you jump into the bond market, you’ll want to be aware of the different types of bonds, specific issuers, as well as variances in their overall characteristics.

Why Are There Different Types of Bonds?

Bonds are commonly known as fixed-income instruments or debt securities because they pay debtholders a specified interest rate that investors can count on. However, there are many different types of bonds with different issuers, maturity dates, characteristics and prices. Bonds can be extremely different from one another; therefore, it’s crucial that you understand the basics of each type of bond to fully understand how you can use them in your portfolio.

Is Bond Investing Right for You?

Even though bonds are typically known to be safe investments, they can be fickle when it comes to inflation and interest rates. If you’re someone who is looking for short-term investment opportunities, bonds may not be the right addition to your portfolio. However, for long-term investors, they may be.

Additionally, if you’re looking for a way to bring in a reliable stream of income, debt securities like bonds could be a suitable option.

And while diversification continues to be a useful risk-management tool, investors should be aware of inflation risk when it comes to choosing between different types of bonds to invest in, as well as the decision of whether to enter the bond market entirely. Bond investors will face more interest-rate risk, as well as credit and liquidity risks, than ever before so you should always be cautious and do your own research.

Lastly, before you choose which types of bonds to invest in, make sure you understand their yield, maturity date and characteristics before deciding to buy.

Types of Bond Issuers

There are two main players in the bond market: bondholders and bond issuers. Bond issuers are the organizations that borrow money to either pay off existing debt or fund new projects. Then, investors, also known as bondholders, will purchase the bonds or other debt securities from the issuers. The bond issuers promise to pay these investors periodic interest and repay the original amount once the bond has reached maturity.

The five main types of bond issuers include:

• Firms
• Governments
• Supranational entities
• Regions and municipalities
• Special-purpose entities (SPEs)

Bond issuers play an important role in the overall capital markets, helping the inefficient allocation of capital by raising money from the investors. In a way, it can be a form of mutualism where the issuers get the desired money for carrying out their projects or operational activities, and investors receive a return on their excess capital for investing in that specific type of bond.

Types of Bonds

Now that we understand the various kinds of bond issuers, we can delve into different types of bonds. These bonds differ based on their issuer, characteristics, prices and maturity dates. The most common types of bonds include:

• Government bonds:
  • U.S. Treasury securities: issued by the U.S. Treasury Department on behalf of the federal government with maturities up to 30 years and tradable on the secondary market
  • Treasury inflation-protected securities (TIPS): Treasury bonds that are indexed to an inflationary gauge to protect investors from the decline in the purchasing power of their money caused by inflation or interest rates
  • U.S. savings bonds: debt securities issued by the U.S. Treasury Department to help pay for the government’s borrowing needs that cannot be traded among parties
  • Agency securities: issued by a government-sponsored enterprise or by a federal government department other than the U.S. Treasury and may have some tax benefits
• Mortgage-backed securities: real estate loans that are compiled and sold to a group of individuals who package the loans together into a bond that investors can purchase
• Municipal “muni” bonds: issued by city, county and state governments, as well as by enterprises with a public purpose, such as certain electric utilities, universities and hospitals
• International and emerging markets bonds: issued by foreign governments and companies that investors can buy to diversify their portfolios
• Corporate bonds: issued by corporations to investors as longer-term debt instruments, with a maturity of at least one year

There are many different types of bonds on the overall market; however, it’s important to understand that only certain kinds are easy to invest in, especially when you are an individual investor. That’s why bond funds can be an easier way to diversify your portfolio and get into the fixed-income universe. The most common types of bonds are corporate, municipal and government.

Characteristics of Different Types of Bonds

To delve into bonds a little deeper is to fully understand the different characteristics each type of bond has. Before you decide what type of bond is right for you, you will want to see how each security pays its bondholders.

• Fixed rate bonds: pay the same level of interest over their entire term
• Floating-rate bonds: interest rate can fluctuate
• Zero-coupon bonds: generate a return at maturity instead of paying out periodic interest to investors
• Inflation-linked bonds: work to reduce inflation risk by increasing in value during periods of high inflation
• Perpetual bonds: no maturity dates, and can be treated as equity not debt
• Subordinated bonds: unsecured debts where investors will not be paid out if the issuer goes bankrupt until after senior bondholders are paid in full
• Bearer bonds: anonymous, held by anyone who is in possession of the bond papers; typically government- or corporate-issued debt instruments that are unregistered
• Serial bonds: mature in installments and are payable several times over their life

There are numerous reasons why financial institutions and investors would want to focus on different types of bond characteristics. Investors may need their fixed-income instruments to have multiple payouts during their lifetimes, as is the case with serial bonds, or they may need additional inflation protection with inflation-linked bonds. Therefore, it’s crucial to do your own research about different types of bonds to invest in before putting your money into a specific kind.

Allocation With Bonds

At first glance, many investors assume that the basic asset allocation decision is an easy one. After all, at this level you are focusing on only two choices—stocks and bonds. The way you allocate your portfolio with different types of bonds will have a major impact on your portfolio’s performance.

AAII’s Allocation Models suggest that you allocate a portion of your portfolio to short- and intermediate-term bonds depending on your personal investor profile: conservative, aggressive or moderate. These can be in the form of individual bonds or bond funds.

Bonds are considered a defensive asset class within a portfolio because they are typically less volatile than other securities such as stocks and equity funds. Many investors include bonds in their portfolio as a source of diversification to help reduce volatility and overall portfolio risk—especially over a long period of time.

It’s important to research which types of bonds you want to include in your portfolio as there are different percentages suggested for different types of investors.

Can You Have Different Types of Bonds in Your Portfolio?

Yes, it is recommended for investors to have a well-rounded, diversified portfolio that has a few different kinds of bonds for various reasons.

Unlike a portfolio with various stocks, ones with different types of bonds can be structured to meet an investor’s exact income needs. If an investor is liquidating stocks for current income, they may be forced to sell their stocks during an unpredictable market where they will end up losing money.

When an investor has a certain number of different types of bonds to supplement their other investments, income can be derived from coupon payments or the return of principal at a bond’s maturity. Any income that is not needed at a bond’s maturity is strategically reinvested in other bonds or bond funds; and because bonds are historically less volatile, they provide the investor with a more predictable source of income.

Over the long run, stocks tend to outperform both bonds and bond funds, but having a mix of both types of securities may reduce your overall financial risk.

As we mentioned above, the AAII Allocation Models suggest that a certain percentage of your portfolio should be allocated to different types of bonds such as short- and intermediate-term bonds. These allocation models are, of course, just suggestions as you will need to determine your own goals and needs before choosing what bonds to include in your portfolio. As we mentioned earlier, not every investor will want to add different types of bonds to their portfolio, so you will need to do your own research before proceeding into this investment category.

Choosing Which Types of Bonds to Invest In

For an individual investor, the three easiest types of bonds to invest in are corporate bonds, municipal bonds and Treasury bonds.

Treasury bonds tend to be the safest investments because they are free of credit risk, but not interest rate risk. Corporate bonds have credit risk, and therefore require investors to evaluate the company’s business prospects and cash flow before investing. Lastly, municipal bonds are known for their tax characteristics. Most municipal bonds are free of federal income tax, which gives investors a slight advantage. As you can see, deciding which types of bonds to invest in will require you to think about your individual goals and needs.

For many individual investors, bonds funds are the easiest and most practical on-ramp to bond investing. Furthermore, bond funds can be a good option if you want exposure to numerous bonds to achieve a diversified portfolio, more competitive pricing when compared to individual bonds and active management, which can be a plus for someone who doesn’t have an immense amount of time on their hands to do their own research.

Determining which types of bonds to invest in should also be based on the timing of your goals and your current life stage. For example, if you are approaching retirement, some would suggest that you start building up your portfolio with bonds instead of individual stocks. If you are busy and do not have time to do your research on bonds, you may want to investigate bond funds. Every investor is different, so the types of bonds to invest in will vary from person to person.

AAII’s Bond Investing Resources

Before you decide which types of bonds to invest in, you will need to understand what is available to you as an individual investor. Do your research on which broker to use, what bonds or bond funds are most liquid and when a good time to invest in debt securities might be. Bond investing may seem daunting at first but learning how each type of bond works will help you determine which is best for you.

At AAII, we offer a variety of educational resources to help you choose which types of bonds to invest in. You can visit the Investing Ideas section on AAII.com to learn about bond yields, maturity dates, convertible bonds and other important information. Additionally, we cover specific topics such as interest rate sensitivity and bond pricing as well as intermediate bond funds in the AAII Journal. Lastly, we have countless resources and tools such as the AAII Allocation Models to use to understand your individual allocation as well as types of bonds so you can build a diversified portfolio.