A percentage of every investment portfolio should be allocated to bonds at some point over an investor's lifetime. This is because bonds provide stable and relatively safe cash flows (income), which is vital for an investor who is in the asset drawdown or capital preservation stage of their investment planning, and for investors nearing that stage. In its most simple terms, if you depend on income from your investments to pay the bills and your daily living expenses (or will in the near future), you should be investing in bonds. In this article we'll discuss several different types of bonds, and identify how each might be used to meet an investor's objectives.

SEE: Advantages Of Bonds

Building Your Portfolio
Unlike an investment in stocks, a portfolio of bonds can be structured to meet an investor's exact income needs because with stocks, the investor might be dependent on uncertain and unpredictable capital gains to pay the bills. Additionally, if an investor is liquidating stocks for current income, they might have to do so at precisely the wrong time - when the volatile stock market is down.

A well-structured bond portfolio doesn't have this problem. Income can be derived from coupon payments, or a combination of coupon payments and the return of principal at a bond's maturity. Any income that is not needed at a bond's maturity is strategically reinvested in another bond for future needs - this way income requirements are met, while the maximum amount of capital is preserved. The bottom line is that bonds provide a historically less volatile less risky, and more predictable source of income than stocks.

Different Bonds, Different Maturities
There are U.S. Treasury bonds, corporate bonds, mortgage bonds, high-yield bonds, municipal bonds, foreign bonds, and emerging market bonds - just to name a few. Each type comes in different maturities (from long-term to short-term). Let's take a look at a few of these bonds closer up.

U.S. Treasury Bonds
U.S. Treasury bonds are considered one of the safest, if not the safest, investments in the world. For all intents and purposes, they are considered to be risk-free. (Note: They are free of credit risk, but not interest rate risk.)

U.S. Treasury bonds are frequently used as a benchmark for other bond prices or yields. Any bond's price is best understood by also looking at its yield. As a measure of relative value, the yields of most bonds are quoted as a yield spread to a comparable U.S. Treasury bond.

Example - Yield Spreads
The spread on a certain corporate bond might be 200 basis points above the current 10-year Treasury. This means the corporate bond is yielding 2% more than the current 10-year Treasury. Therefore, if we assume that this corporate bond is non-callable (meaning the principle cannot be bought out early) and has the same maturity date as the Treasury bond, we can interpret the extra 2% in yield to be a measure of credit risk. This measure of credit risk, or spread, will change according to company specific and market conditions.

If you're wiling to give up some yield in exchange for a risk-free portfolio, you can use Treasury bonds to structure a portfolio with coupon payments and maturities that match your income needs. The key is to minimize your reinvestment risk by matching those coupon payments and maturities as closely as possible to your income needs. You can even buy U.S. Treasuries directly from the U.S. Treasury Department at the same prices (yields) as large financial firms at Treasury Direct.

Corporate Bonds
While not all publicly traded companies raise money through issuing bonds, there are corporate bonds from thousands of different issuers available. Corporate bonds have credit risk, and therefore must be analyzed based on the company's business prospects and cash flow. Business prospects and cash flow are different - a company might have a bright future, but might not have the current cash flow to meet its debt obligations. Credit rating agencies such as Moody's and Standard & Poor's provide ratings on corporate bonds to help an investor assess the issuer's ability to make timely interest and principal payments.

Yield provides a useful measure of relative value between corporate bonds and with respect to U.S. Treasuries. When comparing two or more corporate bonds based on yield, it is important to recognize the importance of maturity.

Example - Bond Yield and Credit Risk
A five-year corporate bond with a yield of 7% might not have the same credit risk as a 10-year corporate bond with the same yield of 7%. If the five-year U.S. Treasury is yielding 4%, and the 10-year U.S. Treasury is yielding 6%, we might conclude that the 10-year corporate bond has less credit risk because it is trading at a "tighter" spread to its Treasury benchmark. In general, the longer the maturity of a bond, the higher the yield that is required by investors. The bottom line is, don\'t try to make relative value comparisons based on yields between bonds with different maturities without recognizing those differences. And, watch out for and recognize any call features (or other option features) that corporate bonds might have, as they will also affect the yield.

Diversification is key to minimizing risk while maximizing return in a stock portfolio - it's equally important in a corporate bond portfolio. Corporate bonds can be purchased through a retail broker with the minimum face value generally worth $1,000 (but it can often be higher).

Mortgage Bonds
Mortgage Bonds are similar to corporate bonds in that they carry some credit risk, and therefore trade at a yield spread to U.S. Treasuries. Mortgage bonds also have prepayment and extension risk - types of interest rate risks associated with the probability that the underlying borrowers will refinance their mortgages as prevailing interest rates change. In other words, mortgage bonds have an embedded call option that can be exercised by the borrower at any time. The valuation of this call option greatly affects the yields of mortgage-based securities. This must be well understood by any investor making relative value comparisons between mortgage bonds and/or other types of bonds.

There are three general types of mortgage bonds: Ginnie Mae, agency and private label bonds.

  • Ginnie Mae bonds are backed by the full faith and credit of the U.S. Government - the loans backing Ginnie Mae bonds are guaranteed by the Federal Housing Administration (FHA), Veterans Affairs, or other federal housing agencies.
  • Agency mortgage bonds are those issued by the home financing government sponsored enterprises (GSEs): Fannie Mae, Freddie Mac and the Federal Home Loan Banks. While these bonds don't carry the full faith and credit of the U.S. Government, they are guaranteed by the GSE's, and the market generally believes that these firms have an implicit guarantee of backing by the federal government.
  • Private label bonds are issued by financial institutions such as large mortgage originators or Wall Street firms.

Ginnie Mae bonds carry no credit risk (similar to U.S. Treasuries), agency mortgage bonds carry some credit risk and private label mortgage bonds can carry a great deal of credit risk.
Mortgage bonds can be an important part of a diversified bond portfolio, but the investor must understand their unique risks. Credit rating agencies can provide guidance in assessing credit risks, but beware - the rating agencies sometimes get it wrong. Mortgage bonds can be bought and sold through a retail broker.

High-Yield Bonds, Muni Bonds, Other Bonds
In addition to the Treasury, corporate and mortgage bonds described above, there are many other bonds that can be used strategically in a well-diversified, income-generating portfolio. Analyzing the yield of these bonds relative to U.S. Treasuries and relative to comparable bonds of the same type and maturity is key to understanding their risks.

Just as with price movements in stocks, bonds yields are not consistent from one sector to another. For example, the yields of high-yield bonds versus emerging market bonds might change as political risks in developing countries change. You can effectively use yield comparisons between bonds and sectors to make a relative value analysis only when you understand where those differences in yields come from. Make sure you understand how the maturity of a bond affects its yield - this includes embedded call options or prepayment options which can change the maturity. (Find out more about these bonds in High Yield, Or Just High Risk?)

Bonds have a place in every long-term investment strategy. Don't let your life's savings vanish in stock market volatility. If you depend on your investments for income or will in the near future, you should be invested in bonds. When investing in bonds, make relative value comparisons based on yield, but make sure you understand how a bond's maturity and features affect its yield. Most importantly, study and understand relevant benchmark rates like the 10-year Treasury to put each potential investment into its proper prospective.

Related Articles
  1. Bonds & Fixed Income

    The Top 5 High Yield Bond Funds for 2016

    Learn about mutual funds and ETFs that invest in high-yield bonds. Read about the risks and rewards associated with investing in high-yield bonds.
  2. Investing

    The Science of Making Better Investment Decisions

    Neuroeconomics attempts to bridge neuroscience, cognitive psychology and economics in order to understand the mechanisms underlying economic decision making.
  3. Mutual Funds & ETFs

    3 ETFs to Consider Before an Interest Rate Hike

    Learn about potential impacts of the Federal Reserve boosting interest rates and three ETFs that can help you capitalize on the perceived December increase.
  4. Stock Analysis

    If You Had Invested Right After Gilead's IPO

    Find out the present day value of your investment in Gilead Sciences and the amount of shares you would own if you had invested during its IPO.
  5. Stock Analysis

    If You Had Invested Right After Costco's IPO

    Find out how much your investment would be worth if you had invested $1,000 during Costco's IPO and how much you would have received in dividends.
  6. Wealth Management

    The Most Important Factors that Affect Mortgage Rates

    Discover what the most important factors are that affect mortgage interest rates. Factors range from inflation and economic growth to Federal Reserve activity, .
  7. Mutual Funds & ETFs

    Why ETFs Are a Smart Investment Choice for Millennials

    Exchange-traded funds offer an investment alternative to cost-conscious millennials who want to diversify their portfolios with less risk.
  8. Investing Basics

    Calculating The Present And Future Value Of Annuities

    Here's everything you need to account for when calculating the present and future value of annuities.
  9. Professionals

    Common Interview Questions for Fixed Income Traders

    Discover a list of potential questions and answers commonly asked in job interviews for a candidate applying for a position as a fixed-income trader.
  10. Stock Analysis

    The Top 5 ETFs to Track the Nasdaq in 2016

    Check out five ETFs tracking the NASDAQ that investors should consider heading into 2016, including the famous PowerShares QQQ Trust.
  1. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
  2. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  3. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  4. Are UTMA accounts escheatable?

    Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
  5. What are the dormancy and escheatment rules for stock accounts?

    While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>
  6. What are the maximum Social Security disability benefits?

    The average Social Security disability benefit amount for a recipient of Social Security Disability Insurance (SSDI) in 2 ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
Trading Center