What Are the Types of Bonds? How They Work & Some Risks Involved

By Myles Leva

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Last Updated: October 25, 2022

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Those who want to make stable investments with guaranteed (fixed) incomes are often directed toward bonds.

Bonds are indeed fixed-income investments that can provide a good deal of stability to the investor. But there are several types of bonds, and fixed-income investors should know the differences.

In this article, we will cover:

  • What bonds are
  • Which types of bonds you can invest in
  • How to invest

 

 

What is a Bond?

A bond is a fixed-income debt instrument made by an investor to a borrower.

Bonds are used by companies and government bodies that need to finance their own operations and investments. They are the result of taking corporate or government debt, and securitizing and issuing it as a tradeable asset.

The owner of a bond is a debtholder. The bond investor is essentially lending money, for which they receive the principal plus interest, which creates their profit.

Bonds are invested in with a timetable. The details include the date when the principal is due. Critically, they also lay out the terms for interest payments. Bond repayment interest can be fixed or variable, each with its own pros and cons for the investor.

 

What are the 5 characteristics of bonds?

All prospective bond investments have 5 characteristics worth considering. These are consistent across all types of bonds:

  • Issuer
  • Maturity date
  • Coupon
  • Face value
  • Yield

 

 

What are the Types of Bonds You Can Invest in?

There are a few types of bonds you can invest in.

Treasury Bonds

Treasury bonds are government debt obligations. They are backed by the full confidence and credit afforded to the government. They are considered one of the safest, and as such offer low yields relative to other bonds.

Treasury bonds offer the highest credit quality and tax advantages. However, they must be purchased in minimal denominations, making them less accessible to some, unless they are purchased to become a major portion of the buyer’s portfolio.

 

Government Savings Bonds

Savings bonds are also backed by the credit of and faith in the federal government. They are used to finance federal spending. Unlike treasury bonds, they are also highly accessible, requiring a minimum investment that’s only a fraction of that required for treasury bonds.

 

Municipal Bonds

Municipalities issue bonds to raise funds for their projects. These normally include local infrastructure and institutions, such as roads and schools, respectively.

Municipal bonds are seen as fairly safe and benign. The investor is investing in the public good, for which they receive tax breaks on top of the income earned from interest payments.

Municipal bonds are purchased from brokers and often have high minimum investments in the thousands of dollars.

Compared with federal government bonds, municipal bonds are riskier, but offer higher yields.

 

Corporate Bonds

Corporate bonds are one of the broadest categories on this list and come in several sub-categories. But broadly speaking, they share the same characteristics.

Bonds issued by corporations are used to help finance the company’s operations and projects. They can vary widely in terms of:

  • Minimum investment
  • Interest rate
  • Variable vs fixed
  • Maturity date
  • Credit quality (risk)

They work the same way as government bonds, more or less. You, as the investor, loan the company money in return for an IOU that includes regular interest payments.

Compared with all government bonds, corporate bonds are:

  • Far more diverse
  • Riskier (but still far less risky than stocks)

Compared to a stockholder in the same company for which you are a bondholder, you are in a safer position. In the case that the company declared bankruptcy and defaults, bondholders are more likely to be at least partially compensated during liquidation.

In terms of diversity, corporate bonds come in differing levels of quality. Investment-grade bonds are issued by companies that are highly rated by credit reporting agencies. Specifically, they’re rated Baa (by Moody's) or BBB (by S&P and Fitch), or higher.

All other bonds that don’t receive those high ratings are non-investment-grade bonds, or “junk bonds”. Junk bonds aren’t necessarily awful, and they produce significantly higher yields. But those higher yields serve as compensation for the higher risk of default that junk bonds carry.

 

Mortgage-backed Securities

Mortgage-backed securities are also referred to as mortgage bonds. They are bonds backed by real estate.

Mortgage bonds are safer than corporate bonds, but not as safe as treasury bonds. In the event of a default, mortgage bondholders can sell off the property backing their bonds to help compensate. But this low level of risk is accompanied by relatively low yields as well.

 

 

What Type of Bonds are Best to Invest in?

This question can be answered according to just two variables:

  • The level of risk you are willing to accept
  • The yields that you want to make, relative to the level of risk

Overall, bonds are a far less risky investment than most alternatives. However, as an investment, they all carry risk and it is still extremely important to consider your personal risk appetite.

If you want the maximum possible level of safety in bond investments, government bonds are the way to go.

Government bonds come with the strongest chances of reaching maturity without an issue. However, they produce relatively low yields, too. The payoff is that they carry the full credit (and faith) afforded to the federal government.

Corporate bonds are on the other end of the spectrum. This is especially true of junk bonds, which carry a higher risk of default. However, many junk bonds produce yields of around 7%, versus around 3% for federal government bonds. Then, municipal bonds fall somewhere in between.

 

Risk Considerations

  • Inflation risk (even in government bonds)
  • Credit risk
  • Market risk
  • Interest rate risk (variable-rate bonds)
  • Default risk

 

 

How Do I Start Investing in Bonds?

Most types of bonds can be purchased through brokers. Brokers include banks, bond traders, individual brokers, and brokerage firms. In many cases, there are more direct routes to investing in them.

Savings bonds can be purchased directly through Treasury Direct, the official website of the US Government.

Corporate bonds, however, are normally purchased through one of the types of brokers listed above.

Photo by RODNAE Productions

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