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What are the six different types of bonds in finance? What tips can help you buy the right ones?
According to economist Burton Malkiel, bonds are worth including as part of a well-diversified portfolio. There are six main types of bonds in finance you should be aware of, and understanding the difference will help you to buy the right ones for you.
Keep reading for an overview of the different types of bonds in finance.
Types of Bonds in Finance
In the post-WWII period through the ’80s, bonds were a losing bet—with low interest rates and growing inflation, many bondholders actually saw negative returns by the time their bonds reached maturity.
Now, however, with more inflation protection attached to high-quality debt, bonds are a worthwhile component of a well-diversified portfolio. In order to know which ones to buy, it’s worth knowing about the different types of bonds in finance.
There are six primary types of bonds in finance you should be aware of:
Zero-Coupon Bonds
The first type of bond in finance is a zero-coupon bond. Zero-coupon bonds (also called “zero coupons” or just “zeros”) offer discounts on their face values in lieu of periodic interest (or coupon) payments. (A typical bond entails interest payments to its holder for the duration of a specified term, after which the principal is paid back in full.)
The central advantage of a zero-coupon bond is its mitigation of reinvestment risk. With a standard bond, depending on market conditions, you might not be able to reinvest coupon payments at a return rate equal to that of the bond. With a zero-coupon bond, however, you’re guaranteed a consistent rate of return on the principal (up to the face value of the bond).
The central disadvantage of zeros is that holders must pay income tax on a prorated difference between the purchase price and face value of the bond. Smaller investors can also be priced out of zeros by high commissions.
No-Load Bond Funds
Ideal for investors who plan to live off interest income, no-load—or, commission-free—bond mutual funds allow purchasers to invest in a variety of bonds with a minimum of ancillary expenses. Funds like the Fidelity Corporate Bond Fund (FCBFX) and the Vanguard High-Yield Corporate Fund Admiral (VWEAX) offer stable returns comparable to zero-coupon bonds.
Tax-Exempt Bonds
Best for high-tax-bracket investors (whose tax liability makes taxable bonds less attractive), tax-exempt bonds are issued by local, state, and other governmental authorities and offer comparable returns to corporate bonds.
If you’re planning to buy these bonds directly—rather than gaining exposure through a mutual fund—then your best bets are new issues. Newer bonds generally offer better yields than established bonds. Two key considerations: Make sure you’re only buying bonds rated A or above by Moody’s or S&P, and try to limit your bond purchases to bonds issued in your own state (which are typically exempt from state income tax).
Also, make sure the bond you’re shopping has a 10-year call-protection provision. This prevents the bond issuer from paying off the debt outright and reissuing the bond if interest rates fall.
Tax-exempt bond fund options include Blackrock Municipal Income Investment (BBF) and Nuveen NY Quality Municipal Income Fund (NAN). These are best for a high-tax-bracket investor only investing a small amount. Investors with more to spend should focus on individual high-quality bonds covered by bond insurance.
Treasury Inflation-Protected Securities
Inflation is a bondholder’s nemesis: It tends to cause interest rates to rise, lowering the price of your bond, and it reduces the purchasing power of your coupon payments.
Enter Treasury Inflation-Protected Securities (or TIPS).
TIPS are Treasury-issued instruments whose face value rises to keep pace with inflation. Say, for example, your TIPS totaled $1,000. If the consumer price index—the default metric for measuring inflation—rose 3%, the face value of your bonds would rise to $1,030 and your coupon payments would be assessed on this new face value.
Although TIPS are a great inflation hedge and portfolio diversifier—because they don’t react to changes in prices like stocks and bonds do—they feature high tax exposure: Both the coupon payments and the rise in face value are taxable. Thus TIPS are best used in tax-advantaged retirement plans.
Junk Bonds
So-called “junk bonds” are bonds with higher yields but lower credit ratings from agencies like Moody’s and S&P. That is, just like with stocks, bonds can offer higher rewards for higher risk.
And just like with common stock, your investing in junk bonds should depend on your tolerance for risk and income needs. If you’re an older investor dependent on interest income (or just risk averse), junk bonds probably aren’t the right investment for you. If you’re a younger investor with a well-diversified portfolio, junk bonds offer considerable upside. In 2018, junk bonds generally yielded 5.5%–7%, whereas investment-grade bonds only yielded approximately 5.5%.
Foreign Bonds
Another option to further diversify a portfolio is foreign bonds (emerging-market bonds in particular can feature high yields). These bonds can be risky, however, so make sure they’re offset by high-quality U.S. assets.
Bond Substitutes
Low interest rates—which have been in effect more or less since the 2008 financial crisis—are anathema to bondholders (because low interest rates equal lower coupon payments).
One strategy to protect yourself against low returns on bonds is to substitute high-dividend stocks. For example, take a company like AT&T. AT&T’s 15-year bond yield is about 4.5%, while its common stock has a dividend yield of 6% and growing. With value companies like these, returns may be better—and equally as consistent—on their stock than their bonds.
The above overview of the different types of bonds in finance will help you make the right decisions when you’re choosing which ones to buy.
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