What is a Bond?
A bond is a loan made by a company, government, municipality, or government agency to an investor (you). As a bondholder, you receive regular interest payments, usually semi-annually, and the value of the principal amount when the loan reaches its maturity. As a fixed-income security, bonds give companies and governments the ability to raise debt capital to fund operations, projects, and other items with a known interest and principal payment schedule.
Bonds are one of the three main asset classes used by investors, financial advisors, and financial planners to create a well-balanced portfolio.
The three main asset classes are:
- Stocks (e.g., dividend stocks, mutual funds, and target date funds)
- Bonds (e.g., more on these below)
- Cash and cash equivalents (e.g., savings account, checking account, and certificates of deposits)
As one of the three pillars of your investment portfolio, bonds help calibrate your risk tolerance, investment time horizon, and financial goals. Bonds can help offset stock market fluctuations and act as a haven during times of high risk and rising interest rates. With regular interest rate payments, you can calculate what your investments will yield.
7 Types of Bonds
There are three main categories of bonds as defined by the Securities and Exchange Commission (SEC) [1]. However, we have broken them out even further to give you a better understanding of what types of bonds might fit into your portfolio. Here are seven bonds to consider:
Corporate Bonds
Corporate bonds are debt securities issued by private and public corporations. These bonds are typically issued to raise capital for business activities like expansion, research, and development, or refinancing existing debt. When you invest in corporate bonds, you're lending money to the issuing company in exchange for regular interest payments, known as coupon payments, until the bond's maturity date, at which point the principal is returned.
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The creditworthiness of the issuing company heavily influences the risk and return of corporate bonds. Creditworthiness is often reflected in their credit ratings, with higher-rated bonds generally offering lower yields and lower-rated bonds offering higher yields but with increased risk. Corporate bonds can vary widely in terms, including interest rate, maturity, and level of security, making them a diverse investment option in the fixed-income market.
U.S. Treasury Bonds
U.S. Treasury bonds are long-term government debt securities issued by the U.S. Department of the Treasury [2]. They are considered one of the safest investment options due to being fully backed by the U.S. government. Treasury bonds have longer maturities, typically 20 to 30 years, and pay interest semi-annually.
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The interest rate, or yield, on Treasury bonds, is a benchmark for the fixed-income market, often influencing the interest rates across various financial products and sectors. These bonds are highly liquid and can be bought and sold on the secondary market. Investors often turn to U.S. Treasury bonds for preserving capital, managing long-term income needs, and diversifying their portfolios, as they provide a relatively low-risk means of earning a steady return over a long period.
Bond ETF
Bond Exchange-Traded Funds (ETFs) offer a dynamic approach to investing in the bond market. These ETFs are traded on stock exchanges like stocks and represent a diversified collection of bond investments. A single bond ETF can include a bundle of bond types, such as corporate, government, or municipal bonds, providing a mix of yields, maturities, and credit qualities.
This diversification helps mitigate the risk associated with individual bond investments. The primary advantage of bond ETFs lies in their liquidity and flexibility. Unlike individual bonds that may be more challenging to buy or sell quickly, investors can trade bond ETF shares throughout the trading day at current market prices.
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Additionally, bond ETFs offer transparency, as their holdings are typically disclosed daily, allowing investors to understand the value of the investments. They also have the added benefit of professional management, where experts handle the selection and timing of the bond investments. For individual investors seeking exposure to a broad spectrum of the bond market without the complexity of managing multiple individual bonds, bond ETFs present an accessible and convenient investment choice.
Municipal Bonds
Municipal bonds (also known as Munis) are issued by state and local governments or their agencies in the United States [3]. These bonds are used to fund public projects such as roads, schools, and infrastructure development.
A key feature of municipal bonds is that their interest income is often exempt from federal income tax and, in some cases, state and local taxes (usually if the investor resides in the state where the bond is issued). This tax-exempt status makes municipal bonds attractive to investors in high tax brackets.
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Municipal bonds come in two primary forms: general obligation bonds, backed by the credit and taxing power of the issuer, and revenue bonds, secured by specific revenue sources like tolls or lease fees. While generally considered less risky than corporate bonds, the safety of municipal bonds can vary based on the municipality’s solvency.
International Government Bonds
International government bonds are bonds issued by countries other than the United States. These bonds allow diversifying their investment portfolio geographically and gain exposure to different economic environments and interest rate trends. The risk and return profile of international government bonds can vary significantly depending on the issuing country's economic and political stability, environment, and creditworthiness.
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Developed countries like Germany or Japan tend to issue bonds that are considered safer but may offer lower yields. However, bonds from emerging market countries offer higher yields and come with increased risk factors, including currency risk. Investing in international government bonds can also be a way to hedge against domestic inflation and interest rate fluctuations. However, investors should also be sure to consider factors like foreign exchange rates and geopolitical risks when investing in these bonds.
Agency Bonds
Agency bonds are issued by government-sponsored enterprises (GSEs) or federal agencies in the United States. Unlike U.S. Treasury bonds, which are fully backed by the U.S. government, agency bonds typically offer a slightly higher yield due to their slightly higher risk.
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For example, the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and the Government National Mortgage Association all issue agency bonds. These agencies finance a variety of activities, including mortgage lending and infrastructure projects.
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Agency bonds are considered low-risk investments and are popular among investors seeking a balance of safety and yield. While agency bonds are not explicitly guaranteed by the U.S. government, the assumption that the government would prevent these agencies from defaulting gives these bonds a high credit rating.
Green Bonds
Green bonds are a rapidly growing category of fixed-income debt instruments designed to fund projects with positive environmental and climate benefits [4]. Green bonds are typically issued by corporations, governments, and supranational institutions that want to fund projects in an environmentally conscious way.
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The proceeds are dedicated to financing or refinancing green projects, such as renewable energy, energy efficiency, sustainable waste management, clean transportation, and sustainable water management. The appeal of green bonds is twofold: in their environmental focus and potential to offer better investment returns than comparable traditional bonds.
Investing in green bonds allows individuals and institutions to support environmentally and socially responsible projects while potentially earning a financial return. As the global focus on sustainability intensifies, green bonds are increasingly seen as a critical tool for financing the transition to a low-carbon, sustainable economy.
Smart Summary
Investing with the right asset allocation mix can let you build a portfolio that aligns with your financial goals. Bonds offer a fixed-income strategy that can be deployed at any stage of portfolio development and ramped up or down depending on how conservative or aggressive your risk appetite is. Knowing the different types of bonds will help you make the smart money choice.
(1) Securities and Exchange Commission. Bonds. Last Accessed November 27, 2023.
(2) Treasury Direct. Treasury Bonds. Last Accessed November 27, 2023.
(3) Securities and Exchange Commission. Municipal Bonds. Last Accessed November 27, 2023.
(4) U.S. Department of Energy. What Are Green Bonds? Last Accessed November 27, 2023.
