Fixed-income investors have a wide range of options regarding the types of bonds they can hold in their portfolios.
Savings bonds are the safest investment there is, since they're backed by the government, and they're guaranteed not to lose principal. They don't offer exceptional yields, but they do offer the highest degree of safety among all of the options in the bond market. They're easy to buy through TreasuryDirect, and they're tax-free on both the state and local levels.
In addition, they may also be tax-free on the federal level and are used to pay for education. The one drawback is that they aren't as liquid (easily bought and sold) as some other types of investments—you can't cash them in within the first year of their life, and if you have to cash them in within the first five years, you will pay a three-month interest penalty.
Despite the deteriorating finances of the United States government, U.S. Treasury bonds remain one of the safest investments out there - providing you hold individual bonds until maturity. In this case, there is no risk of default and interest rate risk isn't a factor. Keep in mind, however, that mutual funds and exchange-traded funds (ETF) that invest in Treasuries don't mature—meaning that they are highly sensitive to interest rate risk. U.S. Treasuries typically offer lower yields than other types of bonds due to their lack of credit risk (or in other words, the risk of default).
Treasury Inflation-Protected Securities
Treasury Inflation-Protected Securities, or TIPS, are a way for investors to help manage the risks of inflation. TIPS' principal adjusts upward along with consumer price inflation (CPI), which provides investors with a guaranteed "real return" (or return after inflation). As a result, TIPS can be an important portfolio component for investors who want to maintain the purchasing power of their savings.
But TIPS, despite being issued by the U.S. government, is not free of risk—particularly if you choose to access the asset class through mutual funds or ETFs - due to their sensitivity to rising interest rates.
Municipal bonds, which are issued by cities, states and other local government entities, are free from federal taxes. And if the bond is issued in the state in which you live, they're also free of state and local taxes. But municipal bonds are typically most useful for investors in higher tax brackets.
For those in lower tax brackets, it may, in fact, pay to invest in taxable securities, since taxable issues typically offer higher pre-tax yields than municipal bonds.
Mortgage-backed securities (MBS) are groups of home mortgages that are sold by the issuing banks and then packaged together into "pools" and sold as a single security. When homeowners make the interest and principal payments, those cash flows pass through the MBS and flows through to bondholders.
Mortgage-backed securities generally offer higher yields than U.S. Treasuries, but they also offer a different set of risks associated with homeowners' ability to repay their mortgages ahead of schedule.
Asset-backed securities (ABS) are pools of loans - typically credit card receivables, auto loans, home equity loans, student loans, and even loans for boats or recreational vehicles—that are packaged and sold as securities via a process known as "securitization".
Only the most sophisticated individual investor would by individual asset-backed securities directly, since a great deal of research is necessary to evaluate the underlying loans. However, if you own a bond mutual fund, there's a good chance that the portfolio has a modest weighting in ABS. Currently, no exchange-traded funds are dedicated solely to asset-backed securities.
Commercial Mortgage-Backed Securities
Commercial mortgage-backed securities (CMBS) are collateralized by commercial real estate loans. Typically these loans are for commercial properties such as office buildings, hotels, malls, apartment buildings, factories, etc., but not single-family homes. While CMBS have default risk, they also offer investors a way to gain exposure to the real estate market without having to invest in stocks, they typically offer an attractive return for the risk than many other types of bonds.
Corporate bonds are simply bonds issued by corporations to fund their operations. Corporate bonds typically offer higher yields than government issues, but they also carry slightly higher risk due to the chance of default (particularly among lower-rated issues). The corporate bond arena offers investors a full menu of options in terms of finding the risk and return combination that suits them best: from short-term to long-term, junior and senior notes, and from very low risk to slightly higher risk.
Corporate bonds are therefore a core component of a diversified income-oriented portfolio.
High Yield Bonds
High yield bonds are issued by companies with outlooks that are questionable enough to prevent their debt from being ranked investment grade. High yield companies might have high levels of debt, shaky business models, or negative earnings. As a result, there is a greater likelihood that they could default.
Such companies, therefore, earn lower credit ratings and investors demand higher yields to own their bonds. Still, high yield bonds (as a group) typically offer higher income than any other asset class, and their historical total returns have been robust.
Senior loans, also referred to as leveraged loans or syndicated bank loans, are loans banks make to corporations and then package and sell to investors. While senior loans are secured by collateral, they're by no means risk-free.
Since these types of loans are typically made to below-investment-grade companies, the level of credit risk is high. Senior loans are riskier than investment-grade corporate bonds but slightly less risky than high-yield bonds. Investors have been paying more attention to this asset class in recent years due to its attractive yields, diversification abilities, and floating rates—a feature that provides an element of protection against bond market weakness.
Investors who only hold domestic bonds may be missing out on the majority of the fixed-income universe—even if their bond portfolios are diversified. Like domestic bonds, foreign bonds are subject to both credit risk (i.e., the risk of default) and interest rate risk (sensitivity to prevailing interest rate movements). However, the international economies don't always move on the same cycle as the U.S. economy—meaning that foreign bonds often provide divergent performance relative to the U.S. market.
Unfortunately, the yields on developed-market foreign government bonds typically aren't much more attractive than U.S. Treasuries, even though investors may also have to assume the risk of currency fluctuations.
Emerging Market Bonds
Emerging market bonds are issued by the governments or corporations of the world's developing nations. Emerging market bonds are seen as being higher risk since smaller countries have been perceived as more likely to experience sharp economic swings, political upheaval, and other disruptions not typically found in countries with more established financial markets. Since investors need to be compensated or these added risks, emerging countries typically offer higher yields than the more established nations.