What Are the Different Types of Bonds?

By Andrew Horowitz

In our last episode, I introduced you to the basics of bonds, including some of the definitions and terms to know when starting your quest to add a safer option to your winning portfolio.  In this episode, we will discuss some of the types of bonds available to you and the risks of investing in these bonds.

What are the Different Types of Bonds?

First, you need to know what type of bond you want to purchase.  There are three main types that most investors chose:

• Treasury bonds:  The safest bond is going to be a Treasury bond, which is backed by the "full faith and credit" of the United States. Though these will be the safest, they will also have the lowest yields. There are three special types of Treasury bonds.  Shorter timeframe bonds --like those which mature in less than two years--are called Treasury bills. These often will have the lowest interest rate of all Treasury bonds.  The intermediate bonds with maturities of 5 to 10 years are called notes. What people most typically think of as bonds are actually the bonds that take 30 years to mature; these bonds usually have the highest interest rate, which means… You can check the current rate of Treasury notes, bills, and bonds at any popular financial website like Google or Yahoo Finance, but be sure to click on the "Bonds" tab instead of the "Stocks" tab.  

  The safest bond is going to be a Treasury bond, which is backed by the "full faith and credit" of the United States. Though these will be the safest, they will also have the lowest yields.

• Municipal bonds: Beneath Treasury bonds on the safety ladder are municipal bonds.  These are issued by state or city governments and they can come in all shapes and sizes—too many to tell you all about here.  They will work the same way as Treasury bonds and it is very unlikely, though it has happened, that cities and state governments go bankrupt and cannot repay their bondholders. 
  
  Some types of municipal bonds might be tax-free, which will hold a lower yield than bonds which are not tax-free, but this might be a distinct interest to you so be sure to note if the municipal bond you are considering is tax-free or not.

• Corporate bonds: Under municipal bonds are corporate bonds, which are bonds from companies like General Electric, Wal-Mart, Clorox, and most large and some smaller companies.  Companies can issue stock to raise money, or they can issue bonds.  The yield you receive from corporate bonds will depend on the stability and reputation of the company: more stable companies offer lower yields whereas less stable companies will offer higher yields.  Remember that companies can go bankrupt, and though it is rare, you need to keep this in mind as a risk before purchasing a corporate bond.

• Foreign bonds: You can also invest in foreign bonds, which--depending on the country-- might be more or less risky than investing in corporate bonds.  Just like the United States issues Treasury bonds, foreign countries offer their own bonds to help fund government operations.  These will be similar to the U.S. Treasury bonds. Fewer Americans invest in foreign bonds so it's much less common to invest in foreign bonds here in the U.S.  Just like with a company, investing in bonds from a more stable country like the United Kingdom, France, Spain, Japan, and Germany will be a safer choice than investing in bonds from smaller countries with unstable governments, histories of violence, or histories of revolution.  Though you might get a higher yield for these smaller countries, don't let yourself be guided just by high yield on your bond.

• Credit Risk:  The credit risk refers to the risk that the issuer of your bond will be unable to pay you either the interest or the full value of your bond at maturity. Always consider this risk when considering bonds.

• Event Risk:  This is the risk that something unforeseen in the company or entity will change over the life of the bond that will affect either the company’s ability to make stable interest payments to you, or its ability to repay the bond in full at maturity.  Unforeseen events might refer to corporate restructuring, a regulatory change by the government, or--in the event you invested in bonds from a small foreign country--a revolution or overthrow of the government.  Yikes!

• Market Risk:  This is a tricky one, and it's something most people don't think about when selecting a bond.  A bond is issued at a certain date and then it matures at a certain date.  These dates might be 5 or 10 years or more apart.  A particular bond is similar to a share of stock, which changes value over time. The actual bond--think of it as an IOU- might rise or fall in value over the years that you own it.   As long as you hold the bond to maturity, this issue should be of no concern to you, as you are guaranteed to receive what you paid for the bond at maturity, unlike a stock.  You can always sell a bond at any time, but you will receive face value for the bond at the time you sell it, which--again-- might be above or below what you paid for it.