- Bonds can usually be relied upon to provide a steady stream of income, even when the stock market hits a rough patch.
- Learn about the differences between types of bonds — based on geography, timeframe, risks and taxation — before you make selections for your investment portfolio.
- Diversified bond mutual funds, ETFs, and index funds are cost-efficient options to consider once you decide to invest.
If you’re beginning to explore the nuanced world of investing, you might have come across bonds. This type of investment is a crucial element of any diversified portfolio, and it should play a key role in your investment strategy.
Adding bonds to your investment strategy can give your portfolio stability and diversification. While other types of investments, such as stocks, can be volatile and unpredictable, bonds are stable and predictable in comparison. They can bring in a consistent source of income over many years, despite changes in the stock market, so long as you hold the bond until its maturity date, and that can counteract any riskier investments you have in your portfolio.
You might be wondering how exactly bonds work. A bond is a type of loan you give an issuer (such as the U.S. government or a corporation), who agrees to pay interest to you over a set period of time in exchange for that loan. The face value (say $1,000 or $10,000), interest rate (such as 3%; also known as the “coupon rate”), and payment schedule (e.g. semi-annually, annually, or at maturity only) are set upfront, making bonds a very predictable investment type. They do carry risk, however, including the risk of default, so it’s important to understand how you are compensated by the interest rates offered by the bonds you’re considering for your portfolio.
Looking to make bonds a part of your investment strategy? Below, you’ll find a guide to help you make bonds a part of your investment strategy. Learn about the various types of bonds based on geographic location, as well as factors to consider such as the maturity date, level of risk, and tax implications.
Bonds by Geographic Region
You can invest in bonds that are both U.S.-based and international, enabling you to participate in both domestic and global economies.
Federal Debt Obligations
These bonds are backed by the U.S. government. Examples of federal debt obligations are U.S. Treasury bills, Treasury bonds, savings bonds. There are also bonds from government-sponsored enterprises (GSEs) like Freddie Mac and Ginnie Mae that carry an implied guarantee.
- Treasury Bonds: Treasury bonds, also called T-bonds, are issued by the U.S. Treasury. They have maturity dates that are anywhere from five years to 30 years. For example, interest rates for 10-year T-bonds currently hover around 2.375% (consult the first column “CPN” for “coupon rate”). They’re considered a very safe investment, hence the lower interest rates compared to others, as they’re backed by the full faith of the U.S. government.
- Savings Bonds: A type of debt issued by the federal government, savings bonds are a loan from you to the U.S. government. They are low-risk and accessible, and can be purchased for anywhere from $25 to $10,000. Savings bond interest is exempt from state and local income tax. Keep in mind that although people may already own savings bonds, they aren’t commonly purchased anymore.
- GSEs: These are bonds that come from entities, such as Freddie Mac and Ginnie Mae, that are sponsored by the U.S. government. These GSEs offer both short-term and long-term bonds, but because their bonds only carry an implied backing of the government, they’re a bit riskier. This means, however, that they carry slightly higher interest rates.
Municipal bonds, which are often referred to as muni bonds, are issued by state and local governments to raise money to support local government agencies and their projects related to local hospitals, roads, schools, etc.
Municipal bonds, while considered relatively safe, carry more risk than federal bonds because they’re not guaranteed by the federal government and depend on local economic conditions or the project the bonds are financing. Minimum investments are typically around $5,000, with interest rates that are currently around 1.8%. Muni bond rates are usually slightly lower than T-bonds because you have the added financial benefit of not paying federal taxes on muni bonds.
Corporate bonds are those issued by public and private sector companies. They carry more risk than government-backed bonds, and to attract investors they offer higher interest rates as a result. Corporate bonds are not tax-exempt, so you’ll have to pay both state and federal tax on them. Corporate bonds typically come in investments of $1,000 each. High-rated, investment-grade corporate bonds typically have interest rates that are 1% to 1.5% higher than T-bonds. Non-investment grade bond interest rates are typically 2.5% to 4% higher than T-bonds, and even higher depending on risks. More on understanding risks below.
A key benefit of corporate bonds is that lenders are paid before shareholders in the event that things go poorly for a company, adding a layer of safety for investors holding bonds.
International bonds are issued by foreign governments and corporations, and come in either U.S. dollars (often referred to as Yankee bonds) or in the foreign currency of the country.
International bonds are common in developed markets — such as the United Kingdom, France, Japan, and Australia — while bonds from emerging markets like Brazil, Mexico, China, the Philippines, and Turkey have also become available. Bonds from emerging markets carry higher risk, but also offer higher interest rates.
You might be wondering why it’d be wise to invest in international bonds as opposed to domestic bonds. There are two primary reasons: They usually offer higher income, and, because of different economic conditions in their home countries, they can provide growth opportunities and a hedge against domestic downturns.
Factors to Consider When Selecting Bonds
When it comes to selecting the bond type that’s ideal for you and your investing needs, you’ll want to take a handful of factors into consideration.
Bonds come in varying maturity dates. Some bonds are “ultra-short,” meaning they’re under one year. These are often referred to as cash equivalents instead of bonds. They’re the most liquid, and they carry the least interest rate risk. An example of an ultra-short-term cash equivalent is a 90-day Treasury bill.
In addition to ultra-short-term bonds, there are both regular short-term bonds and long-term bonds. Short-term bonds are those that are less than four years, while long-term bonds are those that are greater than four years.
Short-term bonds typically offer less risk because you’ll get your money back sooner. The risk of getting your principal back typically increases the more time that passes. Long-term bonds, on the other hand, are slightly riskier since you have to wait longer for your principal to be repaid and they’re also subject to higher interest rate risk.
Most corporate bonds, municipal bonds, and Treasury bonds are long-term, i.e. greater than four years. Not surprisingly, longer-term bonds typically offer higher interest rates to compensate you for waiting longer to be repaid.
Level of Risk
Before selecting which bonds to invest in, you’ll want to take your ideal level of risk into consideration. When it comes to default and credit risk, federal bonds offer the lowest risk, while high-yield bonds (also referred to as junk bonds) and emerging markets bonds offer the highest risk.
In addition, there is always an interest rate risk, meaning there is risk that the interest earned does not keep up with rising interest rates. When interest rates rise, the bond’s price drops because the lower coupon rate for the older bond is no longer as attractive as bonds that are newly issued. Alternatively, when interest rates decline, a bond’s price goes up because the higher coupon rate of the older bond is now more attractive. Short-term bonds have the lowest risk in regards to interest rates, while long-term bonds have the highest risk. If you intend to hold the bonds until they mature, however, interest rate risk generally won’t affect the value of your investment.
When assessing risk, it’s wise to consult the credit rating agencies and view their evaluation of the bond issuer’s ability to pay the promised interest and repay the principal once the bond matures. The “Big Three” credit rating agencies are Standard & Poor’s (S&P), Moody’s, and the Fitch Group. The Big Three also provide their ratings of the financial strength of funds holding a portfolio of bonds. As a smart investor, you want to be appropriately compensated for the risks you take with bonds and any kind of investment.
To complete your bond investment strategy, it’s also wise to know whether or not the bond you’re interested in investing in is subject to taxes. Federal, corporate, and foreign bonds are subject to federal taxes, as well as state and local taxes. However, state, municipal, and local bonds are generally exempt from federal taxes and may also be exempt from state and local taxes if you are a resident.
How to Invest in Bonds
Now that you know about the different types of bonds and what to keep in mind before investing (i.e. maturity date, taxes, and level of risk), it’s time to dig in.
Although you can invest in single bonds on your own, you might want to consider a diversified mutual fund or exchange-traded fund (ETF) that specializes in bonds. A diversified bond portfolio is an efficient, low-cost way to incorporate fixed income into your financial picture. This will not only give you the peace of mind that accompanies working with experts, but it’ll set your investment strategy on a guided path with little management on your part.
In addition, you can consider index funds, which are mutual funds that work based on an index like the S&P U.S. Aggregate Bond Index that tracks investment-grade bonds issued across different geographies, governments and corporations. There are both domestic and international broad bond index funds to choose from.
An important note about taxes: Where bond funds are taxable, meaning they’re composed of bonds issued by the U.S. Treasury, corporations or foreign governments, these bonds are ideally held in tax-advantaged retirement accounts. Consider tax-exempt broad index funds for taxable brokerage accounts, especially if you’re a high earner.
Achieve Your Income and Investing Goals
If you’re looking for an addition to your portfolio that is simpler, more stable, and predictable, consider bonds for a portion of your asset allocation. Bond interest payments are steady and reliable when compared to the ups and downs of stocks in the market, and this income stream can be particularly beneficial for long-term savings goals.
If you’re working with a shorter timeline, you’ll likely want to consider Treasury bills or mutual funds with shorter timelines. If you’re considering a longer timeline and you prefer a low-risk investment, you’ll likely want to select a U.S. Treasury Bond. If you’re working with a long timeline but you’re open to a bit more risk in exchange for higher income, a corporate bond or municipal bond might be the way to go.
Regardless of your timeline, you should always consider mutual funds, ETFs, and index funds that specialize in bonds. These can be a low-cost and efficient way to build your investment portfolio, and they come with the added benefits of diversification and often with expert advice.