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. Budgeting

    Key Questions to Ask Before Moving in Together

    Moving in together is a big step. Here are some key financial questions to ask your partner before you make the move.
  2. Mutual Funds & ETFs

    Top 3 Muni California Mutual Funds

    Discover analyses of the top three California municipal bond mutual funds, and learn about their characteristics, historical performance and suitability.
  3. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  4. Taxes

    Here's How to Deduct Your Stock Losses From Your Tax Bill

    Learn the proper procedure for deducting stock investing losses, and get some tips on how to strategically take losses to lower your income tax bill.
  5. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  6. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  7. Stock Analysis

    3 Solar Stocks to Add to Your Portfolio

    Understand the growth and challenges of the renewable energy market and its success in 2015. Learn about the top three energy stocks to add to a portfolio.
  8. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  9. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  10. Mutual Funds & ETFs

    Top Three Transportation ETFs

    These three transportation funds attract the majority of sector volume.
  1. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  2. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  3. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  4. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  5. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>
  6. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!