Bonds are key investments for any financial plan. When you buy a bond, it’s essentially an “IOU” for loaning a company or government money. Bonds pay interest at predetermined rates for specific time periods, creating an income stream that’s attractive to investors.
Bonds provide important portfolio diversification benefits and might affect your investment returns. For instance, when stock prices fall, bond prices might increase or hold steady, and vice versa. Buying bonds could do the trick if you need to fix your portfolio.
Bond Funds vs. Individual Bonds
You can own individual bonds or buy into a bond fund, which offers “baskets” of various types of bonds. Owning individual bonds requires more money and oversight than owning a bond fund.
Callable bonds give the issuer the option to return your principal investment and stop interest payments before the maturity date, according to TheStreet.com — which might be a reason to opt for a fund instead of individual bonds. Unless you have an awful lot of money and a passion for investment management, it’s best to invest in a bond fund.
When you map out your financial plan, diversify your bond holdings — you can choose from safe government and municipal bonds, corporate bonds, convertible bonds and foreign bonds.
Learn: Who Can Legally Issue Bonds?
Types of Bonds
Bonds’ risk levels vary. For example, junk bonds have a greater chance of default than U.S. government bonds. If you’re interested solely in capital appreciation, you might want to consider zero coupon bonds, which are sold at deep discounts and which you can cash in for the full face value when they mature.
A wide variety of bond types is available. Here are details on some bonds, so you can decide which would make the best additions to your investment portfolio.
A municipal bond is a debt security offered by a state or local government that might need cash for public projects. Munis are tax-free and they provide a variety of benefits for investors including a semiannual coupon payment.
Muni bonds might be good for you if you’re in a high tax bracket: They offer a cash flow and they’re exempt from federal taxes. If you live in the bonds’ issuing state, you also won’t have to pay state taxes. Municipal debt is also very safe and has a low default risk.
Issued by private companies to raise money for new projects, operations and acquisitions, corporate bonds are available in several varieties. When you buy a bond fund or individual corporate bond, you’ll receive regular coupon payments. The riskiness of a corporate bond depends upon its credit quality; higher rated bonds are safer than lower rated ones.
Corporate bonds vary by:
- Maturity date — from one to 30 years
- Credit quality — from investment grade to high-yield bonds or junk bonds
- Type of bond
Related: 9 Best Short-Term Investment Options
Convertible bonds come with an option to convert them into shares of the issuer’s common stock at a predetermined price. Investment-grade corporate bonds are suitable for moderate risk level investors seeking higher returns than government debt provides. Lower rated and junk bonds are for speculative investors seeking high returns.
Foreign bonds — also known as international bonds — account for approximately a third of worldwide investment assets, according to Kiplinger. You can choose from country-specific to general global bond funds. The Vanguard Total International Bond Index (VTABX) fund gives you access to non-U.S. investment-grade bonds.
Foreign bonds can provide the broadest portfolio diversification. These funds are generally less correlated with U.S. bonds but are subject to risks like currency fluctuations and country specific perils.
Federal Government Bonds
U.S. government bonds are considered the safest bonds available because there’s little risk of default. Here are a few of the U.S. savings bonds and federal government bonds you can buy at TreasuryDirect.gov:
- EE Savings Bonds: EE Bonds are low-risk savings products that pay interest for up to 30 years.
- Treasury Inflation-Protected Securities: TIPS protect your cash by increasing in principal value as inflation increases. You can buy individual TIPS in five-, 10- and 30- year increments, or you can buy into a TIPS bond fund. These securities are exempt from state taxes.
- I Savings Bond: I Bonds’ interest payments adjust with the inflation rate and earn interest for up to 30 years, which you can start redeeming after the first year. You can purchase only $10,000 of I Savings Bonds per year and you can buy them in denominations as small as $25. You won’t have to pay state taxes on them, either.
- Treasury bills, notes and bonds: These are three types of federal debt that earn a fixed rate of interest for various terms. Treasury bills are short-term, fixed-income securities with maturities ranging from a few days to 52 weeks. Intermediate-term Treasury notes are available in two-, three-, five-, seven- and 10-year maturities.
- Government Treasury bonds: An important component of your bond portfolio, these bonds provide a safe investment for your cash and fixed investment dollars. Government debt is great for financing education, supplementing retirement income, giving as a gift, or diversifying your investments.