How to Choose the Best Types of Bonds to Buy

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Most investors buy bonds to generate timely income. Technically, a bond is a loan made from an investor to a bond issuer. For most bonds, issuers promise both regular interest payments and the return of principal to bond investors. There are many distinctly characterized types of bonds, offering an array of potential benefits and pitfalls, underscoring the old adage “Buyer Beware.” Updated, this translates better to “Buyer Be Aware.” The following list of bond types and features can help you choose the best bonds.

Government Bonds

Government bonds are still considered the secure gold standard. All of these types of bonds are backed by the full faith and credit of the United States government, meaning their risk of default is essentially zero. All government bonds are tax-free on state and local levels. Five main types of government bonds are available:

Treasury bills are short-term securities with maturities of 52 weeks or less. They don’t pay interest; instead, they’re issued at a discount, with the face value paid at maturity.

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Treasury notes and bonds deliver interest every six months, with face value paid back at maturity. The difference lies in their term lengths: Notes mature in two, three, five, seven, or 10 years, whereas bonds mature in 30 years.

EE savings bonds earn a fixed rate of interest for up to 30 years. Bonds used for higher education expenses might be able to avoid federal taxation.

Treasury inflation-protected securities are issued in terms of five, 10 and 30 years and pay a fixed rate of interest. Their principal value rises and falls, however, with changes in the consumer price index.

Government securities generally appeal to conservative investors looking to protect their principal. They’re also of benefit to investors in states with high income tax rates.

Read: Advantages and Disadvantages of Treasury Bonds

Corporate Bonds

Corporate bonds are issued by individual companies come in a wide range of maturities. Corporate bonds are not backed by the federal government, nor are they insured, so the only assurance investors have that they will receive their interest and principal is the financial strength of the issuing company.

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To help investors determine the quality of these types of bonds, most are rated by outside investment agencies, such as Standard and Poor’s, Moody’s or Fitch. The agencies rank bonds in four top categories, considering investment grade, whereas bonds rated below these are deemed high-yield or junk bonds. Typically, the lower the rating, the higher the interest rate the issuing company will have to pay investors. Corporate bonds are appropriate for investors looking for higher returns while willing to accept a higher level of risk.

Municipal Bonds

Municipal bonds are issued by states, cities and counties, often to fund public works projects, frequently involving infrastructure. Most municipal bonds are federally tax-free, providing the most attractive fiduciary benefit for investors. Most municipal bonds are also state tax-free for investors buying them in the state where they reside.

A large number of municipal bonds are insured by outside agencies, giving them the highest rating of AAA on the Standard and Poor’s bond-rating scale. Even if the underlying entity goes bankrupt, the insurance company will pay back investors, making these types of municipal bonds significantly safer.

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Zero Coupon Bonds

If you don’t need immediate income but are instead funding a long-term obligation, such as a college education, a zero-coupon bond might be the best option. These types of bonds don’t pay regular interest but are bought at a discount, as in the case of a Treasury bill, and they pay off the face value of the bond at maturity. The U.S. government issues zero-coupon bonds, known as STRIPS, and many municipalities also offer zero-coupon bonds.

Corporate zero-coupon bonds also exist, but they aren’t as plentiful as government or municipal zeros. Government STRIPS and corporate zeroes have a “phantom tax” structure —although no money is paid until maturity, you’ll still be responsible for paying tax on them every year as long as you own them.

Bond Funds

Bond mutual funds are pools of money deposited by individual shareholders, collectively invested in bonds by professional money managers. Bond funds typically pay monthly interest, which makes them attractive to investors who need income more frequently, rather than semi-annually. Bond funds don’t have maturity dates, so there is no date at which principal is returned to investors. When individual bonds inside the fund mature, that money is immediately reinvested into new bonds. If you want to get your money back from a bond fund, you’ll have to sell your shares and accept their current market value.

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Choosing the Best Bonds

For a bond buyer, choosing the best investment requires analysis of a number of different factors. Ultimately, your investment objective and time frame will direct the category of bond most appropriate for you. For example, if you’re in a high tax bracket, you might benefit from the tax-free nature of municipal bonds, or to a lesser degree, government securities. Investors looking for a higher return might turn to the corporate bond market, where higher yields are available in exchange for higher risk to principal. Investors who don’t want to put in the time to analyze individual bonds might be better off with a bond fund, providing instant diversification and the comfort of having a professional making higher risk choices.

Regardless of type, all bonds carry risks. Although government bonds might have very little credit risk, mainly from issuer default, they still carry interest rate risk, meaning bond prices will fall as interest rates rise. Other bond risks include:

Not all bonds are subject to all risks. For example, TIPS are specifically designed to combat inflation risk, as their principal rises in response to increasing inflation. Government bonds are not subject to liquidity risk, as the U.S. Treasury market is the largest and most liquid market in the world.

When choosing the best bonds, a buyer must balance risk and reward, as with any other type of investment. If you’re buying bonds to generate interest, look for the highest yield you can get while remaining within your sphere of risk tolerance. Consider the time needed to mature your bonds, as longer-dated bonds are typically more sensitive to shifts in interest rates. When comparing interest rates on bonds, factor in your tax bracket to determine if your net yield would be higher with tax-free bonds.

Related: 10 Safe Investments With High Returns
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