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Bonds are considered one of the three core asset classes (stocks and cash or cash equivalents like certificates of deposit are the other two). Also known as a fixed-income security, bonds allow governments and corporations to raise funds for projects and operations. Whether you’re trying to balance out your portfolio, reacting to a stock market correction or looking for a steady stream of income, bonds are an important part of any investment portfolio.
A little about how that works: When you buy a bond, you (the investor) are loaning money to a borrower such as a company, municipality, government or government agency. In return, you receive interest on your investment at regular, scheduled intervals. Buying a bond differs from buying stock in that you are loaning cash rather than buying a stake (or equity) in a company. The interest you earn on bonds can also provide a steady source of income.
Bonds are considered a relatively safe financial investment and are often used as a tool for creating balance in your portfolio — especially against the volatility of other investments such as stocks. Your goals, risk tolerance and timeline should inform what balance of stocks, bonds and cash (or cash equivalents) feels right for your portfolio.
» Learn more about bonds vs. stocks
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Types of bonds
1. U.S. government bonds and securities
Governments worldwide sell bonds and securities to print money, fund government spending and services and pay down debt. U.S. government and agency bonds and securities carry the "full faith and credit" guarantee of the U.S. government and are considered one of the safest investments. What that means: regardless of war, inflation or the state of the economy, the U.S. government pays back its bondholders. As such, they're considered a safe investment option.
The U.S. Treasury sells securities in the form of Treasury bills, notes and bonds. Treasury bills carry no interest, or "zero coupon," and a maturity ranging from several days to 52 weeks. Treasury notes are fixed-income securities with maturities at two, three, five, seven and 10 years. Treasury bonds, also known as T-bonds, are long-term, fixed-income securities with terms from 10 to 30 years. Interest income from Treasury securities is exempt from state and local taxes. These securities can be bought for a minimum of $100 through Treasury Direct or a broker.
U.S. Savings Bonds and TIPS
Two of the most common types of U.S. savings bonds are I-bonds and Series EE Savings Bonds. I-bonds are a favorite safe investment vehicle, known for “virtually no credit and default risk,” according to the Financial Industry Regulatory Authority. Priced at $25, they’re an accessible investment choice for a new investor.
Treasury Inflation-Protected Securities, or TIPS, and STRIPS are U.S. government bonds protected against inflation and a low-risk investment choice for inflation-wary investors. The minimum price to invest is $100.
Agency securities are bonds issued by either federal government agencies or government-sponsored enterprises, known as GSEs.
The Government National Mortgage Association, also called GNMA or Ginnie Mae, is a U.S. federal agency whose debt is guaranteed by the U.S. government. As a result, agency securities carry virtually no risk.
GSEs Fannie Mae and Freddie Mac are corporations the U.S. government created to address public concerns like affordable housing. Fannie Mae and Freddie Mac agency securities have excellent credit, are low risk and offer higher yields than U.S. Treasurys and savings bonds.
Some agency securities, such as bonds that fund the Tennessee Valley Authority, have the benefit of being exempt from state and local taxes. While it does vary, the minimum price to invest in agency securities is $10,000, and they can be bought through a broker.
2. Municipal bonds, or munis
Local governments raise funds to improve public infrastructure like schools and roads by selling municipal bonds. Since an investment in a municipal bond is an investment in a public good, munis are a relatively safe investment that also receives tax breaks on the income earned from interest. Typically, no federal income tax is levied, and you may also benefit from state and local tax exemptions. Munis can be purchased through a broker, generally at a minimum of $5,000. While they offer more risk than a U.S. government bond, they also typically have higher yields.
» Municipal bonds: What they are and how to invest
3. International and emerging markets bonds
The U.S. government is not the only country you can invest in. Like corporate bonds, there are many shades of international and emerging market bonds with varying interest rates, maturity dates and credit quality. However, since there is no international bond regulator, information can be harder to come by, meaning you may have to make a trade with incomplete information. “Sovereign risk” details the risk profile for a particular country and the likelihood that the country will default on its debt. Political and economic instability can affect the bond’s risk of default and whether your bond is repaid.
4. Corporate bonds
There are many types of corporate bonds, with varying interest rates, maturity dates and credit quality. Say you want to buy a corporate bond, which helps fund Corporation X’s operations. You, the investor, buy and receive a bond as a corporate IOU. In return, you get regular interest payments. The risk you take as an investor varies depending on the creditworthiness of the corporation, and unlike certain government bonds, is affected by inflation and rate hikes.
While corporate bonds may carry relatively more risk than a U.S. government bond, they are still generally less volatile than stocks. If a company goes bankrupt and is liquidated, bondholders are more likely than stockholders to receive part of their initial investment.
Corporate bonds are graded investment or non-investment grade. Non-investment grade bonds, or "junk bonds," are considered higher risk and earn higher returns than investment-grade bonds or U.S. government bonds. However, you also run a higher risk of default, or not getting your money back.
You can invest in corporate bonds through a broker. For more information on bond trade and transaction data, you can also use TRACE, the Trade Reporting and Compliance Engine. TRACE is a U.S. government price dissemination service that provides access to transaction data for all eligible corporate bonds.
» Understanding corporate bonds and how to buy them
5. Bond ETFs
If you'd like to easily diversify your bond holdings, bond exchange-traded funds allow you to conveniently invest in a basket of bonds. Bond ETFs can offer a further layer of diversification within the bond asset class.
6. Green bonds
Socially conscious investors may also want to consider investment options like green bonds and other ESG funds. For investors who want to make returns and a difference, investment vehicles driven by environmental, social and governance principles are a growing option.
Green bonds, for instance, follow sustainability principles that include guidance on the use of proceeds, the process for project evaluation and selection, the management of proceeds and reporting.
Which type of bond is right for you?
Finding out which bond type is for you is often a matter of assessing:
How much money you have to invest.
How long you want to stay invested.
How much risk you are willing to tolerate.
What interest you want your investment to earn.
The advantages of a particular bond or bond exchange-traded fund.
You can buy bonds through a broker or directly from the U.S. government. You can also buy bonds on secondary markets, or sell them there as well if you decide you want out early.
» How to invest in bonds: A quick-start guide for beginners