Bonds can play a useful role in your investment portfolio, as a source of diversification and a buffer against stock market volatility. But before you start making trades, you’ll need to know the different types of bonds and how they affect your investment strategy.
An overview of bonds
When you buy a bond, you’re essentially acting like a banker. That’s because a bond is a loan agreement between the bond issuer (an entity such as a municipal government or a company) and bondholder (an individual or institutional investor). Governments and corporations issue bonds when they need to borrow money to pay for things like infrastructure and operations. That could be a city’s new bridge, or a company’s pricey research and development program. Not all bonds are created equal. There are multiple types of bonds with unique risk levels and earning potential, as well as other advantages and disadvantages. Let’s go over them.
Types of bonds
Provincial bonds
Provincial bonds are issued by provinces and are considered pretty safe because provinces have steady income from taxes and other sources. However, they're not quite as safe as bonds issued by the Canadian government. People and companies buy these bonds to earn interest on their money while helping provinces pay for things like schools, hospitals, and roads.
Municipal bonds
Municipal bonds, or “munis” for those in the know, are securities issued by state and municipal governments to fund specific projects, such as the construction of a new bridge or improvements to a school.
The most common types of municipal bonds are general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuer, which can tax residents in order to meet bond obligations. Revenue bonds on the other hand aren’t backed by the issuer’s taxing power but from revenues that come from a specific source, such as highway tolls. A subset of revenue bonds are what’s called “non-recourse,” meaning that if the revenue stream connected to the bond peters out, the bond issuer no longer has to pay you.
There are also bonds issued by a municipal government on behalf of private groups, such as non-profit colleges or hospitals. But if these organizations can’t pay back the original debt, the government isn’t responsible for the outstanding amount.
Municipal bonds are relatively safe, but they come with more risk than sovereign government bonds (we’ll get into these further down) because the issuer is a much smaller entity.
Depending on your country and location, you may not have to pay taxes on the income from municipal bonds. In the United States, the interest you earn is tax free at the federal level and tax-free at the state level if you live in the state of the bond. Lower interest rates make municipal bonds attractive, which encourages investors to invest in civic projects.
Convertible bonds
A convertible bond is a type of corporate bond that the holder can convert into cash or shares of the issuing company at any time. The number of shares you get when you convert the bond are predetermined.
Convertible bonds offer higher yields (how much you earn) than government bonds, but lower yields than conventional corporate bonds. Investors also like these bonds because they come with the flexibility to turn into stock at pre-set times during the life of the bond, meaning they can capitalize when the stock grows to a point where it looks like an attractive security.
Why do companies issue convertible bonds? These securities allow corporations to pay a lower interest rate to bondholders because the conversion feature creates an upside for investors. Convertible bonds also allow corporations to deduct the interest they pay out as an expense, and can be a good option for companies that have lower credit ratings but high expectations for their growth, such as a startup.
Junk bonds
Junk bonds are also called high-yield bonds or speculative bonds. These are corporate bonds with the lowest possible ratings from investment ratings agencies like S&P or Moody’s Investors Service, which means the companies are not financially sound and at higher risk of defaulting.
While junk bonds are the riskiest type of bonds you can buy, they’re still generally safer than stocks. They also offer higher yields, with interest rates that are several times higher than government bonds in order to entice investors.
Foreign bonds
Foreign bonds are bonds issued in a domestic market by a foreign issuer. The issuer offers the bond in the domestic market’s currency. For example, a Japanese company may issue a bond in the Canadian market using Canadian dollars.
As an investor, the challenge here is that the issuer makes the interest payments in another currency. In order to withdraw that money or use it for investments in your currency, you have to convert it. There are fees associated with converting currency, which fluctuate over time. If you invest in foreign bonds, you’ll have to make sure the cost of converting the currency doesn’t wipe out your return at the time you convert it.
These kinds of bonds are useful for diversifying your portfolio, but they come with some risk depending on the market you’re investing in. An unreliable market could eat into your nest egg. Furthermore, you have to consider the volatility of the exchange rate. If the rate is known to move around a lot, it may be high when you need to sell the bond.
Investment-grade corporate bonds
Corporate bonds are bonds issued by corporations, LLCs, partnerships, and other commercial entities. These are bonds that have BBB or better credit ratings from S&P or Moody’s. These bonds don’t come with much risk of default because the investing services have evaluated them and declared them to be low-risk.
Nevertheless, companies that issue corporate bonds aren’t as resilient as governments or municipalities, so there’s more risk. This also means higher returns.
Non-conventional bonds
All of the other bonds on this list are conventional because their value, interest payment frequency, interest rate, and maturity date are predetermined. A non-conventional bond, however, is one where those variables can change with time.
For example, zero-coupon bonds are non-conventional bonds that don’t pay interest every year. The issuers pay all of the bond’s interest when it matures. They can be issued by governments or corporations.
These types of bonds are not common for most investors unless you have a very clear understanding of the security and how it fits into your overall portfolio.
