When it comes to investing, people often want to know what the safest options are. After all, it’s your hard-earned money on the line – and while investing is a must for most who want to retire one day, it can be hard to swallow the risk.
But the reality is that investments and risks are all about balance. Experienced investors (and their advisors) know that you don’t have to choose just one investment type. A strong portfolio is well-diversified, with a range of investments that balance each other out.
One of the best ways to add balance to your portfolio and mitigate investment risk is to purchase bonds. The world of bonds is rich and varied, with many different options available to buy. In this guide, we’ll be exploring the basics of investing in bonds, as well as the most common bond types.
Understanding Bonds
Purchasing a bond is essentially lending money to a company or the government. You and the bond issuer agree on an amount, a fixed rate of interest, and a specific length of time before they have to pay you back – with interest. When that time is up, the bond issuer (government or company) pays you back with that previously agreed upon interest.
The end date of a bond agreement is referred to as the bond reaching “maturity.”
There are several different types of bonds, but the most common are:
- Government bonds
- Municipal bonds
- Corporate bonds
- Treasury bonds
Each of these bond types come with their own characteristics and potential risks/returns (which we’ll explore more later on in this blog).
Bonds vs. Stocks: What’s the Difference?
The big difference between bonds and stocks is this: With a bond, you are loaning money to a company (or the government) that they agree to pay you back with interest. With a stock, you are buying a piece of the company, which is then tied to the company’s fortunes – whether good or bad.
As a result, bonds are generally considered safer than stocks because they’re a fixed-income investment.
No one knows what the stock market will do from day to day. Sure, some companies are considered “safer” investments than others, but the stock market can be extremely fickle. When you buy a stock, there is literally zero guarantee that you will make money (that’s why we’re such big fans of long-term investing, diversification and discipline).
Bonds, on the other hand, come with a much higher likelihood of payback – most of the time. High yield bonds, a.k.a. “junk bonds,” carry a high risk of default and are thus below investment grade – we do not recommend these! (You might remember them from the movie “The Big Short.”)
With bonds, both you and the company/government agree to predetermined terms: namely, the timeline of the loan and the interest rate for payback.
Bonds: Less Risk, Lower Returns
The common rule of investing is that returns are directly connected to risk. High risk = high (potential) returns. Due to their lower inherent risk, bonds typically offer a lower return rate than stocks, which have outperformed bonds by about 20% since the Great Depression.
While all investing comes with some amount of risk, adding bonds to your investment strategy along with stocks can result in a properly diversified portfolio that mitigates risk.
Common Types of Bonds
As we stated above, the four most common types of bonds are government, municipal, corporate and treasury, and each comes with its own pros and cons.
Treasury Bonds
Treasury bonds (also known as T-bonds) are issued by the U.S. Department of the Treasury to finance the national debt and other government expenditures. They are considered to be among the safest investments in the world because they are backed by the full faith and credit of the U.S. government.
Treasury bonds are often issued with longer terms than other bond types, traditionally clocking in at 10 years or more. And while treasury bonds are subject to federal income tax, they’re exempt from state and local income taxes.
You may have heard of I bonds, a popular financial vehicle currently experiencing a higher than usual interest rate thanks to inflation.
Government Bonds
When most people hear the word “bonds,” they picture one of those WWII-era posters encouraging private citizens to buy bonds to support the war efforts.
Those posters were part of a campaign to sell government bonds, a specific type of bond used to fund government spending. Since they are backed by the U.S. government, they’re generally seen as a very low-risk type of investment, and thus carry lower return rates, typically between 5% and 6%.
Municipal Bonds
Municipal bonds (or “munis”) are issued by state and local government entities, like public schools or utility companies. These bonds are used to fund roads, schools, hospitals and more.
While municipal bonds are considered slightly riskier than government bonds, they’re also considered safer than corporate bonds. Returns vary pretty widely. Case in point: In 1995, municipal bonds had a return rate of 17.4%. In 2022, they had a return rate of -13.1%. To be fair, 2022 was literally the worst year for bonds in the history of bonds.
Pro tip: While government bonds are subject to federal income tax, many municipal bonds are exempt from federal taxes (although state and local taxes often still apply).
Corporate Bonds
Corporate bonds are issued by corporations and businesses, who use the money to fund business costs like operations or growth. While corporate bonds often come with a higher interest rate, they also depend entirely on the company for repayment. Essentially, if the company goes under, there’s a good chance they won’t be paying you back.
Investors can gauge risk by investigating the issuing company’s credit rating. Those with particularly low credit ratings are referred to as high-yield bonds or junk bonds. Like we said before, the higher the risk, the higher the (potential) returns (and also like we said before, we don’t recommend these!).
There are many types and sub-types of bonds available, but these four are by far the most common in the United States. If you want to start investing in bonds but aren’t sure where to start, a financial advisor can help you through the various options available and make a decision.
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