Bonds are important elements of every well-rounded investment portfolio. 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
What is a bond? It’s essentially an IOU. A bond is an agreement between a borrower (the bond issuer) and a lender (the bondholder). Issuers want to borrow money and they’re willing to pay interest for that privilege. Bondholders want to lend money, but need to be compensated with interest. The bond, therefore, is a promise to pay back a debt.
The bond issuer pays interest to the bondholder every month throughout the life of the bond. At the end of the bond—its maturity—the bond issuer pays back the bond holder’s initial investment. These variables are predetermined before you buy a bond. In most cases, the bond ceases to exist when it reaches maturity, but you can always buy more.
Like other securities, it’s best to purchase bonds early. Thanks to compounding interest, the earlier you start saving in a high interest savings account, the less you have to invest each year to meet your financial goals.
Bonds are considered one of the more stable kinds of securities you can hold in your investment portfolio. However, less risk means they come with lower returns than other kinds of securities (like stocks). This doesn’t mean all bonds are equally safe and equally profitable. And of course there is always some risk when you invest.
Types of bonds
All bonds aren’t the same. Different types of bonds have unique risk levels and earning potential, as well as other advantages and disadvantages.
1. Sovereign government bonds
These are bonds issued by sovereign governments. In the United States they are called U.S. Treasury bonds. In Canada they’re called Canadian Treasury Bonds, and in the U.K. they’re called Gilts.
Sovereign bonds are tradable, fixed-income bonds backed by the full faith and credit of the country’s treasury. These are considered one of the safest investments on the market because the state has the power to tax its people to meet its obligations. (Note: “Safe” doesn’t mean free of risk.)
But with low risk comes low returns. Sovereign government bonds are one of the weakest performing securities in terms of profit.
2. Municipal bonds
Municipal bonds are securities issued by local governments and municipalities to fund specific projects. For instance, a city might issue a bond to pay for the construction of a new bridge. Or a town might issue a bond to pay for improvements to school.
Municipal bonds are relatively safe, but they come with more risk than treasury bonds or other government bonds 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.
3. Agency bonds
Agency bonds are bonds issued by government agencies, rather than the treasury. But like treasury bonds, they are backed by the full faith and credit of the government. You can expect regular interest payments from the issuing agency and the full face of the bond remitted to you at the maturity date. They are a bit less liquid than treasury bonds, however, so they offer a slightly higher interest rate.
Agency bonds can also be issued by government sponsored entities. These are quasi-government organizations that are privately owned but heavily regulated and given a mission to provide public services. Bonds from GSEs are not fully guaranteed in the same way as sovereign government bonds and municipal bonds, so they come with a higher risk.
4. 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 ratings from Standard & Poor’s or Moody’s Investors Service. These bonds don’t come with much risk of default because the investing services have evaluated them and declared them to be low-risk. (We’ll talk about bonds with lower ratings in a minute.)
Nevertheless, companies who issue corporate bonds aren’t as resilient as governments or municipalities, so there’s more risk. This also means higher returns. That said, there are no tax advantages to these bonds.
These kinds of bonds are classified by their maturity:
Short-term bonds: Five year term or less.
Intermediate bonds: Maturity between five and 12 years.
Long-term bonds: 12 year term or more.
5. Convertible bonds
A convertible bond is a type of corporate bond that the holder can convert into shares of the issuing company at any time. The number of shares you get when you convert the bond are predetermined.
Like corporate bonds, convertible bonds offer higher yields (how much you earn) than government bonds. Investors also like these because they come with the flexibility to turn into stock at any time, like when the stock grows to a point where it looks like an attractive security.
When do companies issue convertible bonds? 1. When they can deduct the interest they pay out as an expense, which doesn’t apply if they just issue simple stock, 2. When the conversion option creates an upside for investors, which gives the company the ability to pay lower interest rates, and 3. When the bonds are converted to equity and the company is relieved of its obligation.
6. 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 the 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 great for diversifying your portfolio, but they come with some risk depending on the market you’re investing in. An unreliable market could cost you 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.
7. Junk bonds
Junk bonds are also called high-yield bonds or speculative bonds. These are corporate bonds with the lowest possible ratings from the investment services, which means the companies are not financially sound. This means they are high risk.
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.
8. 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.
Pros and cons of investing in bonds
Now that you understand the bonds in the different types, let’s talk about why you should or shouldn’t make them part of your investment portfolio.
The pros of investing in bonds
What are the advantages to holding bonds in your portfolio?
1. Bonds have fixed returns. You know exactly how much you’ll earn by holding the bond in terms of interest and principal at the end. Your returns don’t depend on a company’s value going up or down.
2. Bonds are less volatile. Whereas the value of stock floats up and down every day, the value of a bond is only influenced by current interest and inflation rates, which are typically quite stable and predictable.
3. You can buy funds of bonds. A bond fund is a security that invests in multiple—sometimes hundreds!—of bonds at one time. This spreads out the risk among many bonds to diversify your portfolio.
4. You can invest in bonds with automated investing. Bond funds are an important part of intelligent investing, which is why robo-advisors like Wealthsimple include them in most portfolios.
5. Bonds come with credit ratings. Unlike stocks, every bond gets a rating from one of the investment services - Standard & Poor’s and Moody’s. This helps you choose a bond that fits into your portfolio without doing hours of research.
6. Bonds have less risk than stocks. They earn specific payouts, so they won’t fall in value. Also, bondholders get paid before shareholders if a company goes bankrupt.
The cons of investing in bonds
What are the disadvantages to holding bonds in your portfolio?
1. Bonds have fixed returns. This is an advantage because it creates safety, but it’s also a disadvantage because it means your investment will never grow beyond the interest payments you receive. Since all money has an opportunity cost, you might learn more by investing that money in a security with a higher yield.
2. Some bonds are less liquid. Liquidity is your ability to convert an asset into cash. While most bonds are easily tradable on the market, others—like local municipal bonds, foreign bonds, and non-conventional bonds—may be harder to sell.
3. Bonds expose you to interest rates. National interest rates affect bond rates more directly than stock prices, so the interest payment of the bond may fall while you hold it.
How to Invest in Bonds
Ready to add bonds to your investment portfolio? Your first step is to open an investment account. The sooner you invest, the sooner you’ll take advantage of compound interest and grow your nest egg.
