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What are the different types of bonds, and how do they work?

Highlights:

- Bonds are an investment product that allows everyday investors to essentially loan money to governments and corporations.

- Bonds pay interest and typically provide predictable, stable returns for the life of the bond.

- Depending on the type of bond, these investments can be risk-free, moderately risky, or very risky — and the available rates of return can also vary significantly.

The world of investing has lots to explore. There are many different types of investments to choose from. The most well-known asset class is equities, a category which includes stocks.

Another common asset class is fixed income, a category that includes bonds. But what are bonds, exactly? And how do they work?

This guide will go over the bond basics that parents, teens, and kids need to know — including the various types of bonds you can invest in.

What are bonds?

A bond is a financial instrument that investors can purchase from governments or companies. The issuing party agrees to pay the investor back over time, with interest. You can think of bonds like loans, but you (the investor) are the one making the loan to the bond issuer (the borrower).

To illustrate, let’s look at an example.

A company needs $100,000 to fund a new project. They decide to issue 10 bonds for $10,000 each with a 12-month maturity date, and they offer to pay 7% interest. The company then sells these bonds to investors.

An investor could then buy a $10,000 bond. That money would go to the company, who could then use it to fund their project. Twelve months later, the company would pay the investor $10,700 (the $10,000 principal plus $700 in interest).

Bonds can be issued by governments, corporations, agencies, and local municipalities. They can range from virtually risk-free to very risky, depending on the type of bond.

Other aspects of bonds can vary as well, including:

  • The interest rates they pay (sometimes called the “coupon rate”)

  • The length of the bond’s term (listed as the “maturity date”)

  • The repayment schedule and how interest payments are distributed

  • The value of the bond and whether it’s sold at face value or at a discount

  • Their availability and whether or not they are available on the secondary market (essentially “used bonds”)

This introductory guide to bonds will focus primarily on the different types of bonds available to investors today.

Advantages of bonds

  • Bonds can help to preserve capital (or avoid loss) and diversify an investment portfolio.

  • Most bonds provide predictable returns via interest payments.

  • Bonds can provide a steady stream of income from both interest and principal repayments through the term.

  • They are available as individual bonds or in bond funds.

Disadvantages

  • Some bonds can still be risky.

  • Bonds tend to have lower returns than growth assets like stocks.

  • Bond investments can be sensitive to changes in interest rates.

What are the different types of bonds?

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Bonds are available from governments, private companies, municipalities, and more. The safest bonds include things like Treasury bills, which have virtually zero risk and are backed by the U.S. government. 

On the high-risk, (potentially) high-reward side of the spectrum, you have high-yield bonds (so-called “junk bonds”). Junk bonds are a risky bet because they are issued by companies that have lower credit ratings and that might be financially unstable — like early-stage startups or heavily indebted firms.

Here’s an overview of different investment products available on the bond market.

Government bonds

Government bonds are offered directly by the government. While most world governments issue bonds, this section will focus on bonds from the United States government.

In general, U.S. government bonds are very safe and low risk. They are backed by the full faith of the United States government. 

Various investment-grade bonds are available from the U.S. government, including:

  • Treasury Bills: Short-term securities with a maturity ranging from four to 52 weeks. May be sold at a discount, and redeemed for full value once matured.

  • Treasury Notes: Fixed-income securities with maturity ranging from two to 10 years. Pay a fixed rate of interest.

  • Treasury Bonds: Long-term fixed-income securities with maturities of either 20 or 30 years. Pay a fixed rate of interest and can be resold at any time on the secondary market.

  • Treasury Inflation-Protected Securities (TIPS): Long-term securities with maturities of five, 10, or 30 years. Pay a fixed rate of interest, and the par value of the original security can increase or decrease based on the rate of inflation.

  • Series I Savings Bonds (I bonds): Flexible bonds that can be redeemed any time after 12 months and up to 30 years. Earn a hybrid interest rate with a fixed rate component and a variable rate based on the current inflation rate.

  • Series EE Savings Bonds (EE bonds): Unique bonds that are guaranteed to double in value after 20 years. The fixed interest rate may change in the last 10 of its 30 years.

U.S. government bonds are sold through TreasuryDirect. You can open an account directly there. Many mutual funds and bond ETFs also invest in government bonds, and those funds can be purchased through normal brokerage accounts.

Because government bonds are so low risk, they typically pay lower interest rates than other types of bonds. The risk of default for the U.S. government is very low. With that said, the Series I savings bonds sometimes present a good value when inflation rates are high.

Agency bonds

Agency bonds are offered by specific agencies within the U.S. government — but not directly by the Treasury. For instance, the Federal Housing Administration (FHA) could issue bonds directly. These bonds can also be offered by government-sponsored enterprises, such as Fannie Mae or Freddie Mac.

Agency bonds often are less liquid (harder to sell) than Treasury bonds and notes. As such, they tend to carry higher interest rates — although they are still generally quite low risk.

Agency bonds can be purchased directly from government agencies and also sometimes through third-party brokers.

Municipal bonds

Municipal bonds, or “munis,” are offered by local municipalities, like cities or counties. They are often issued to raise funds for a specific project, like a new city park or a highway renovation.

Municipal bonds can vary in risk level and interest rate. They may have favorable tax treatment as well — some may even be free of federal income tax liability.

Municipal bonds can be purchased directly from municipalities and/or through third-party brokers.

Corporate bonds

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Corporate bonds are offered directly by companies. For instance, Microsoft could issue a bond to help finance the development of a new software product.

Corporate bonds can vary significantly in risk level and in interest rates. It all depends on the credit risk of the company, as measured by their credit rating.

Third-party organizations — like Moody’s, Fitch, and Standard & Poor’s — maintain ratings for corporate borrowers based on their financial statements and repayment history. A company that has consistently paid on time and hasn’t defaulted will receive a good rating, while companies with a higher risk of default will receive a lower rating.

A corporation’s credit rating affects investor appetite for their bonds and, therefore, the interest rate they must offer in order to attract investments. A very trustworthy company may offer a relatively low rate of return on their bonds, while a new startup may be forced to offer a much higher interest rate (but their bonds will be more risky).

Corporate bonds are sold directly to initial investors and also offered on secondary markets.

International bonds

International bonds are bonds offered by entities outside of the United States. The term could refer to international corporate bonds as well, but it’s usually used to reference government bonds offered by foreign nations.

For instance, France may issue a bond to cover a budget deficit, or Rwanda may issue bonds to fund infrastructure projects.

Like corporate bonds, the risk and returns of international bonds vary greatly. Some countries have a very low risk of default, while others carry much more risk.

Bond funds and bond ETFs

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Bond funds and ETFs are investment products that offer exposure to bonds, without direct ownership. For example, a mutual fund might invest in a wide variety of bonds and sell shares of that mutual fund to individuals.

A fund may manage $100 million and invest that money in dozens or even hundreds of different bonds. Investors could then buy into the mutual fund itself and would be entitled to a share of the fund’s returns.

Bond funds are a good way to improve diversification in an investment portfolio. They are also simpler to buy, as they are available in just about every brokerage or retirement account.

Bonds are one way to start investing!

Bonds are kind of like loans. You, the investor, buy a bond from the bond issuer — and the issuer promises to pay you back over time, with interest. The details vary depending on the type of bond, but that’s the basic concept!

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