Bonds for Fixed Income Investors

Clearing up the finer details
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Fixed-income investors have a wide range of options when it comes to the types of bonds they can hold in their portfolios. If you invest in fixed-income securities, or bonds, you know the value of a steady payout over time, until the asset matures. Whether they pay dividends or make payments based on interest earnings, all bonds come with a lifespan, after which time you can expect to receive your initial investment back. The details of these payments, maturity dates, and returns, will vary based on the type of bond, and there are many types.

Bonds can be formed into a basic spectrum of risk and return, so chances are you'll be able to find a bond, or many, to suit your goals.

Savings Bonds

Savings bonds are the safest investment there is, since they're backed by the U.S. government, and they're guaranteed not to lose principal. They don't offer very high yields, but they are among the most secure options in the bond market. They're easy to buy through TreasuryDirect, and they're tax-free on both the state and local levels. Savings bonds may also be tax-free on the federal level if they are used to pay for higher education, through certain programs.

The one drawback to savings bonds 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 penalty worth three months of interest.

U.S. Treasuries

No matter the state of the U.S. economy, U.S. Treasury bonds remain one of the safest investments out there, so long as you hold single bonds until maturity. In this case, there is no risk of default, and interest rate risk isn't a factor. Most U.S. Treasuries offer lower yields than other types of bonds due to their lack of credit risk (or in other words, the risk of default).

Keep in mind that mutual funds and exchange-traded funds (ETF) that invest in Treasuries don't mature. This means that they are highly sensitive to interest rate risk.

Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities, or TIPS, are a way for investors to help manage the risks of inflation. The way TIPS work is that the principal adjusts upward along with consumer price inflation (CPI). If you invest in TIPS, this feature provides you with a guaranteed "real return" (or return after inflation). As a result, TIPS can be an important piece of your portfolio if you're looking to maintain the purchasing power of your savings over time.

But TIPS are not free of risk. If you choose to access the asset class through mutual funds or ETFs, the risk may be greater, due to their sensitivity to rising interest rates.

Municipal Bonds

Municipal bonds are issued by cities, states, and other local government entities. As a rule, they are free from federal taxes. And if you purchase the bonds from the state in which you live, they're also free of state and local taxes. The main value of municipal bonds is based on this tax break, and they may be 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 most taxable issues offer higher pre-tax yields than municipal bonds.

Mortgage-Backed Securities

Mortgage-backed securities (MBS) are groups of home mortgages that are sold by the banks that serve as lenders to the home loans. They are packaged together into "pools" and sold as a single security. When homeowners make monthly payments, those cash flows pass through the MBS and then through to you, if you hold these bonds.

Mortgage-backed securities tend to offer higher yields than U.S. Treasuries, but they also offer a new set of risks. Since they come from a sequence of payments and sources, their returns depend on whether homeowners can repay their mortgages ahead of schedule, or even on time.

Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities (CMBS) are collateralized by commercial real estate loans. Most of 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 can also offer a way to gain exposure to the real estate market without having to invest in stocks. And compared to other types of bonds, the return on CMBS most often outweighs the risk.

Asset-Backed Securities

Asset-backed securities (ABS) are pools of loans that are packaged and sold as securities via a process known as "securitization." They can be made of of many types of loans, such as credit card receivables, auto loans, home equity loans, student loans, and even loans for boats or RVs.

Only the most savvy and experienced investor would buy single asset-backed securities directly. This is because it takes a great deal of research to assess the underlying loans. But 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.

Corporate Bonds

Corporate bonds are simply bonds issued by corporations to fund their operations. For the most part, corporate bonds offer higher yields than government issues, but they also carry slightly higher risk due to the chance of default (mainly among lower-rated issues). The corporate bond arena offers a full menu of options in terms of finding the balance of risk and return. You can find what suits you best: from short-term to long-term, junior and senior notes, and from very low risk to slightly higher risk.

Corporate bonds are often used as a core piece of a diversified income-oriented portfolio.

High Yield Bonds

High yield bonds are issued by newer companies or those with shaky outlooks. High-yield companies might have high levels of debt, somewhat unclear business models, or negative earnings. As a result, there is a greater chance that they could default. In fact, high yield bonds are also called "junk bonds" because their debt cannot be ranked as investment grade.

As a result, such companies earn lower credit ratings and investors demand higher yields to own their bonds. Still, high yield bonds (as a group) can offer higher income than any other asset class, and their historical total returns have been robust.

Senior Loans

Senior loans, also referred to as leveraged loans or syndicated bank loans, are loans that 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 often made to companies that rank below investment grade, the level of credit risk is high. Senior loans carry more risk than investment-grade corporate bonds, but are slightly less risky than high-yield bonds. Investors have been watching this asset class in recent years due to its high yields, diversification uses, and floating rates. This last feature provides a degree of protection against bond market weakness.

International Bonds

Investors who only hold domestic bonds may be missing out on the bulk of the fixed-income market. This is true even if their bond portfolios are diverse. Like domestic bonds, foreign bonds are subject to both credit risk (i.e., the risk of default) and interest rate risk (sensitivity to current rate changes). But the international economies don't always move on the same cycle as the U.S. economy. As such, foreign bonds often perform in ways that contrast the U.S. market.

On the other hand, the yields on developed-market foreign government bonds aren't much better than U.S. Treasuries. It's worth noting also that if you invest in international bonds, you may 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 a higher risk than other types since smaller countries have been perceived as more likely to suffer from sharp economic swings, political distress, and other factors not always found in countries with older and more secure markets. Since investors need to be paid for these added risks, emerging countries tend to offer higher yields than the more settled nations.

The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.