Types of Bonds Explained

This article takes a look at what types of bonds are available for investors.

But before we get into that, it’s worth going over what bonds are and why you’d want to stick you money in them anyway. After all, historically stocks have provided the big returns, not bonds.

Bonds are really just loans. Where they differ from the usual loan you encounter is that the roles become reversed. You become the lender, and the receiver of your loan pays you interest for your trouble.

There any many reasons to have bonds in your investment portfolio, but perhaps the most compelling is risk reduction.

Having bonds in your portfolio doesn’t just reduce the risk of you losing money, perhaps more importantly, it reduces the risk of you doing something stupid when the stock market crashes.

A perfect investor wouldn’t worry about a stock market crash. They’d be relaxed in the knowledge that crashes happen from time to time, and that stocks have always recovered and reached new highs.

And that’s great, but there are three problems with this as far as I can see:

1. I’ve never met a perfect investor.
2. Stock markets don’t always recover. Just ask Japanese investors whose market is way down off the highs that happened decades ago.
3. Seeing wealth disappear before your eyes has a habit of making people forget they shouldn’t sell when the stock market drops. Emotion takes over when your bank balance is going down double digits in real time.

It’s also not beyond the realms of possibility that bonds could outperform stocks. This has happened in the past and is bound to happen at some point in the future.

If you are sure you could handle your balance dropping by 50% then read no further, stick all your money in stocks, fasten your seatbelt, and get ready for a bumpy ride.

But if like most people, you have your doubts about your ability to control your emotions under severe financial strain, its probably worth having bonds in your investment portfolio.

And if you are going to invest, it makes sense to get an understanding of the different types of bonds available.

The most common types of bonds

1) Developed market government bonds

Also called treasury bonds or high quality government bonds.

These are highly rated bonds of developed market governments such as the US, UK and Germany. The interest payments you receive are low but so too is the risk.

In fact, they are often described as riskless or risk free. Whether that’s true is debatable but its pretty much agreed that they are just about as safe an investment as you can make.

Many investors hold these as a diversifying assets, because they tend to hold their value if not go up when stocks go down.

The most famous developed market government bonds are Treasuries and Gilts.

Treasuries are the name used to describe US government bonds. The vast majority of investors have some treasuries in their investment portfolio.

You’ll often hear the terms: Treasury bills, Treasury notes, Treasury bonds and TIPs. The difference for the first three is the time you hold the bond, usually called the maturity.

Bills have maturities of one year or less, notes have maturities between 2 and 10 years, bonds have maturities between 10 and 30 years and TIPS are Treasury Inflation-Protected Securities. As the name suggests, TIPS have a return that fluctuates with inflation.

Gilts are British government bonds. The unusual name comes from the fact that they used to have gilded edges.

2) Developing market government bonds

Also called emerging market bonds.

These are government bonds of developing market countries. They tend to come with higher interest payments than developed market bonds, but also higher risk.

As an example, at the time of writing a UK 10 year government bond pays less than 1%, whereas an Indian 10 year Government bond pays about 7%.

On the face of it 7% looks a lot more attractive than 1%, but bonds don’t tend to pay high interest rates without reason. The extra 6% you get, is compensating you for the increased risk of default i.e. not getting your money back. (You can read more about bond defaults here.)

3) Investment-grade corporate bonds

Also called high quality or highly rated corporate bonds.

Investors lend money to high quality companies, and get interest payments in return. Investment grade means these companies are unlikely to default, meaning there’s a good chance you will get your money back!

Investment grade corporate bonds are likely to be from big name companies that you’ve heard of, such as Apple or Microsoft.

Even though the chances of them defaulting is low, it is still likely to be higher than a developed market government, so the yield is likely to be higher too.

A bond’s risk is rated by agencies like Standard & Poor’s and Moody’s.

A Standard & Poor’s rating of BBB or above and a Moody’s rating of Baaa3 or above signifies investment grade (IG). Ratings below these are considered non-investment grade.

4) Non investment grade bonds

Also called low quality corporate bonds, junk bonds and high yield bonds.

The clues are in the names. This type of bond generally pays more interest, hence high interest! But that’s because it is more likely for something to go wrong meaning you might not get your money back, hence low quality or junk!

Non investment grade bonds making double digit interest payments aren’t too hard to find, but as with developing market bonds, high interest payments suggests high risk.

5) Municipal bonds

Also called munis.

Common in the US, they are issued by a non profit organization, a private sector corporation or alternative public entity. They use the loan for public projects like schools, roads, railways, airports and hospitals.

They usually provide very low yields, but on the plus side, interest payments are exempt from federal income taxes.

These are popular with US investors that want to minimize the tax they pay.

6) Savings bonds

Different countries have different kinds of savings bonds. Some make regular interest payments and some pay all the interest at the time when you get your money back. Savings bonds tend to be offered by Banks, Building Societies and Governments, rather than companies.

The key difference between savings bonds and other types of bonds is that they are non-marketable meaning they can’t be bought and sold on the open market. They are a contract between you and the bond issuer.

7) Premium bonds

There are two meanings for premium bond. The first is a bond which trades above its face value i.e. you would need to pay more to buy the bond than the amount you get back when you eventually cash it in.

People pay more than the face value for the interest payments they will receive. Bond prices typically increase when interest rates go down.

Another meaning, is a type of bond issued in the UK. Unlike traditional bonds that pay interest, premium bonds work more like a lottery.

Every bond is entered into a monthly prize draw. Each one is worth £1 and has an equal chance of winning a prize, so the more you buy the more chance you have of winning.

The top prize is £1,000,000, though there are lots of different prizes starting at £25. Any prizes are tax free and you are guaranteed by the British government to get your money back whenever you want it.

These are very popular in the UK, particularly with people who want to minimize the tax they pay.

The downside with this type of bond is that you are unlikely to win, and in the meantime inflation is corroding the value of your savings.

On the plus side its like buying a lottery ticket for free.

Oh yeah, and did I mention you might win £1,000,000!

8) Inflation linked bonds

Also called inflation indexed bonds or inflation protected bonds.

As the name suggests, inflation linked bonds are linked to inflation, which means they increase in value with inflation.

For example, let’s say you invest in a £100 inflation linked bond with a 5% interest rate paying £5 per year. Let’s also say that inflation is 10%. The inflation linked bond will increase in value by 10% inline with inflation so your bond will now be worth £110.

Furthermore, your interest rate will also increase because 5% of £110 is £5.50. On the downside, inflation linked bonds usually have marginally lower interest rates or coupons than their nominal bond equivalents.

On the upside, unlike other bonds, there is no risk that they are going to lose purchasing power. They don’t correlate particularly well with stocks or other bonds either, so they can add further diversification to your portfolio.

Inflation linked bonds from developed market governments are considered extremely safe.

9) Zero-coupon bonds

Also known as strips or zeros in the US. This type of bond doesn’t pay a coupon, which means they don’t pay interest. Rather, they are sold at a discount.

You buy an £80 bond for example, then get £100 back when its time to collect your money. Even though you don’t get any interest payments you are still charged tax on the interest you would have had.

10) Mortgage backed securities

Made famous by the book the Big Short and movie by the same name describing the shenanigans that led to the financial crisis of 2007.

They represent a stake in a bucket of mortgage loans, which enables you to receive the interest and principal payments rather than them going to the original bank that issued the loan.

But anybody who’s read the book or watched the movie will know that this type of product is not without risk.

The bottom line

When you choose which bonds to invest in, you need to think about the length of time you will hold the bond, the risk associated with it and the interest payments you are gong to receive.

Moving away from developed market governments and increasing the maturity add risk. All else being equal the higher the interest payments the higher the risk.

You can invest in one bond, two types of bonds or you can invest in lots of different types of bonds.

These days more and more investors gain easy access to baskets of bonds through bond exchange traded funds (ETFs).

You can read more about bonds here.