Bond investing is something every new investor should understand. Whether you are building a specific 3 fund portfolio, or simply deciding on your asset allocation, the types of bonds you choose matter.
From government bonds to corporate bonds, they all play a similar role in your portfolio – diversification. However, there are distinct differences between them, and understanding those differences can help you decide how to get started.
Before highlighting three major types of bonds, we’ll start with the basics, what is a bond?
What is a Bond?
A bond is essentially a loan.
When you invest in a bond, you loan money to a government or corporation, and in return, you receive an interest payment. It’s like how a mortgage works with your bank, but in reverse.
Simple Bond Definition: A loan that an individual investor makes to a government or coroporation.
The mechanics of how a bond works are straight-forward when viewed from a high level.
A bond has a coupon rate (interest rate), maturity date, and face value. All fancy words with simple meanings.
Bond Terminology to Know:
Face Value: The agreed-upon value of the bond at maturity.
Coupon Rate: The amount of interest a bond will pay out until maturity. For example, if a $1,000 face value bond has a 3% coupon rate, then the bond will pay $30 per year. In general, coupon rates get better (higher) as the risk of the bond increases.
Coupon Date: When the coupon payments will be paid out to investors, and how often.
Maturity Date: The date at which the bond matures and is bought back for face value.
If a government wants to raise money, they might offer a 10-year bond that is worth $1,000 with a 2% coupon rate. The buyer of that bond would earn 2% every year ($200 in total if the value of the bond does not change) and at the end of the 10 year period they would get their initial $1,000 back, on top of the $200 they earned along the way.
The value of bond investments is that they are typically lower risk than equity or stock investments.
With a stock, the company’s value could go down and stay down, causing you to eventually lose money on your investment. This is why I like to spread my equity investments across many stocks through index funds, to lower the risk of one declining stock to impact my portfolio.
With a bond, you are guaranteed a fixed payment (more or less), and you only lose money if the underlying company or government goes out of business entirely. There is less day to day volatility, but also less upside. Your gains, for the most part, are fixed.
Don’t get me wrong, bonds still have risk, just less risk than stocks.
Three Major Types of Bonds
Not all bonds are created equal.
In fact, there are many different bonds and more types of them than I care to count. However, while the list of bonds that are available to investors is long, below are the three most common to know:
1. Treasury Bonds (Soveirgn Government Bonds)
A treasury bond (T-bond) is a bond issued by the US government that provides interest payments until the maturity date.
A treasury bond is one of the four types of fixed income (treasury securities) offered by the US government, which also includes:
- Treasury bills: Similar to T-bonds, but with a maturity length of less than 1 year
- Treasury notes: Similar to T-bonds, but with a maturity length of 1 – 10 years
- TIPS (Treasury inflation-protected securities): Designed to protect against inflation
US government bonds are considered the gold standard of fixed income and are virtually risk-free. As long as the US government is still kickin’, you’ll get paid.
Treasury Bond Highlights:
|Bond Issuer:||US federal government|
|Maturity Length:||10 – 30 years|
|Coupon Date:||Semi-annual payment (every six months)|
|Tax Implications:||Federal Only|
The US government is not the only sovereign government to offer bonds, but if you live in the US, generally, it is recommended to get bonds through Uncle Sam. They are viewed as safer than foreign bonds.
2. Municipal Bonds
Municipal bonds (munis) are bonds offered by US state and local governments. Typically, local governments issue bonds in order to raise funds for local projects, such as highways and schools.
The biggest perk of investing in municipal bonds is that they are tax-exempt by the federal and state government. So, don’t put any in your Roth IRA!
In general, there are two different types of muni bonds:
- General Obligation Bonds: These bonds are not tied to a specific local project, but are paid back using regular tax income
- Revenue Bonds: These bonds are tied to a specific revenue-generating project, like a toll-road or stadium, and are paid back using the proceeds from that project
Municipal bonds are viewed as slightly riskier than T-bonds but are still low-risk investments when compared against equities.
Treasury Bond Highlights:
|Bond Issuer||US state and local governments|
|Coupon Date||Semi-annual payment (every six months)|
3. Fixed-Rate Corporate Bonds
Corporate bonds are issued by corporations rather than governments. Instead of raising funds through issuing equity or stock, companies have the financial option to raise money by issuing bonds, which is a form of debt.
These types of bonds can be short-term, medium-term, or long-term, similar how to Treasury bills, notes and bonds vary in duration.
Although, perhaps the most important factor to consider when choosing a corporate bond is the rating. Both Moody’s and Standard and Poor’s are credit rating agencies that rate corporate bonds on a scale of D to AAA (Technically, Moody’s only goes down to C last time I checked). Much like in school, getting a “D” is not a good sign, it means the issuer of the bond is already in default.
These two companies, Moody’s and Standard and Poor’s, are the”watchdogs” in the industry. They aim to hold these corporations accountable and ensure consumers know what they are investing in.
The last thing to call out on corporate bonds is that fixed-rate bonds are not the only type of corporate bond. They are the most common, and often referred to as “plain vanilla bonds” because of it, but there is one other option worth noting: convertible bonds.
Convertible bonds are similar to fixed-rate bonds, except you have the option to convert them to shares of stock if you desire.
Corporate Bond Highlights:
|Bond Issuer||A Company or Corporation|
|Tax Implications||Federal and State|
Other Quick Facts to Know:
Zero-Coupon Bonds: Zero-coupon bonds are another type of bond that does not offer coupon payments. Instead, it is sold at a discount to its face value and later bought back at face value.
Callable Bonds: These bonds give the issuer the option to buy back the bonds before the maturity date.
How to Invest in Bonds
When it comes to investing in bonds, you have two main options:
- Buying bonds directly
- Buying bonds through a fund or ETF
Buying through your broker will be easier to manage, and will likely give you more options. Though, you’ll also pay a larger fee (spread) to make the purchase than if you were to buy them directly through the issuer.
Buying direct from the issuer can save you money, but will require a little more work on your end to manage and track. For example, you can buy bonds from the US government through the site Treasury Direct.
Regardless, when buying direct through either option, you need to consider the extra work that will come with it:
Extra Work #1: Diversifying
Like with stocks, you usually don’t want to buy just one bond or type of bond. You want a few to diversify your portfolio.
Extra Work #2: Laddering
On top of diversifying your options, you also need to consider when bonds maturity dates are, or when they expire. Most investors don’t want all of their bonds to expire in one day, so they ladder the expiration dates by buying various length bonds over time.
Through a Fund or ETF
Your other option, which is my preferred option, is buying through an index fund or ETF.
I like investing in a bond market fund for a couple of reasons, but the main one is that the fund does all the work. You don’t have to worry about laddering or buying bonds directly. Instead, the fund purchases bonds on your behalf.
The trade-off with a bond fund, as with equity funds, is that you have to pay an expense ratio.
For example, SCHZ (Schwab U.S. Aggregate Bond ETF) invests the variety of bonds seen below and charges an expense ratio of 0.04%.
Most of these bonds offer a different coupon rate and have varying maturity dates. The fund is constantly selling and replenishing its portfolio of bonds, and paying you a monthly dividend along the way.
Are Bonds a Good Investment?
Yes, in my opinion, bonds can be a good investment.
However, bonds are not risk-free. They are just less risky than equity.
The general recommendation with bonds is to increase the allocation of this type of asset as you grow older. One rule of thumb is to invest your age in bonds.
So a 20-year old might have 20% of their portfolio allocated to bonds, while a 60-year old who is near retirement could have 60%.
Personally, I think this a good rule of thumb to give you an idea of how much of your portfolio to allocate to bonds, but I don’t think it should be followed blindly.
If you are a very risk-averse investor, you might want to lean more heavily on bonds. However, some people (including Warren Buffett) consider keeping as little 10% of their portfolio allocated in bonds well into their 40s or 50s, or older.
It all depends on your risk tolerance.
Summary: Types of Bonds
Bonds are a great asset to diversify and de-risk your portfolio. they can provide relatively stable levels of fixed income, and you have three options or types of bonds to choose from:
- Treasury Bonds
- Municipality Bonds
- Corporate Bonds
Hopefully, this simple breakdown of the most common types of bonds will be helpful in helping you decide how much of your portfolio to allocate to bonds.