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Bringing new bond asset classes to your portfolio
Many investors may not look much beyond U.S. Treasuries when focusing on bond investments.
But adding other types of bonds to your portfolio may bring benefits such as diversification,
additional yield, and a better chance of keeping up with inflation. Here are some
details about different types of bonds you may want to include in your portfolio.
Treasuries are bonds issued by the U.S.
government and classified by the length
of time before maturity:
- Treasury bills have maturities of less than a year
- Treasury notes (1-10 years)
- Treasury bonds (more than 10 years)
These bonds are often considered extremely safe,
because of the very low chance the U.S.
government will default, or not be able to
pay back bondholders.
However, because of this safety of principal,
government bonds often pay lower interest
rates, which may not keep up with inflation
over the long term.
Corporate bonds are debt securities
issued by corporations. They are a way for
companies to raise money by borrowing
money from the investors who purchase
the bonds. Corporate bonds are given a
credit rating based on the likelihood the
company will default. The company's credit
quality is very important: higher-quality
bonds generally pay lower interest rates.
Corporate bonds, as well as Treasuries,
are affected by interest rate movements.
Generally their prices will go up when interest
rates go down, and vice versa.
High-yield bonds are corporate bonds
rated Ba or lower by the bond rating
agency Moody's or BB or lower by the Standard & Poor's bond rating agency.
These ratings mean the bond has a higher
default risk. To compensate investors for
taking on this additional risk, high-yield
bonds pay higher interest rates.
This type of bond may be less affected by
changing interest rates and more affected
by changes in the issuing company's
credit rating.
Convertible bonds are another type
of corporate bond. These can be converted
into the company's stock at certain
times, usually at the bondholder's discretion.
These bonds generally pay lower
interest rates in exchange for the value of
the option to convert the bond into stock.
The share price of the underlying stock is
an additional factor that affects the price
of these bonds.
International bonds are bonds issued by corporations or governments in countries
outside the United States in a currency other than U.S. dollars. Not only do
these bonds give U.S. investors exposure to another country's bond market, they
also provide exposure to a foreign currency. So the exchange rate between the
foreign currency and the U.S. dollar affects the investor's results.
These factors can be positive or negative. Sometimes the bonds of a foreign country
offer higher yields than U.S. bonds. But investing in countries outside the United
States also entails additional risks, such as fluctuations in exchange rates, different
political and economic conditions, and different accounting standards.
Yankee bonds provide a way for U.S. investors to participate in foreign bond
markets without taking on currency risk. These are bonds denominated in U.S.
dollars and issued in the United States by foreign banks and corporations.
Municipal bonds are issued by a state, municipality, or county to finance local
projects such as building schools or bridges. The main advantage of these bonds
is that the returns are free from federal tax. Sometimes local governments will also
make the returns non-taxable for residents. Because of the tax savings they can
offer to investors, municipal bonds usually offer lower yields than taxable bonds.
These bonds are often popular with investors in higher tax brackets. However, for
some investors, the income from these bonds may be subject to the alternative
minimum tax.
Individual bonds versus mutual funds
In general it takes a much larger investment to buy an individual bond than it does
to buy an individual stock. Corporate bonds, for example, typically have a face value
of $1,000. For that reason, mutual funds make more sense for many investors who
want to own a diversified bond portfolio. Bond funds, also referred to as income
funds, allow investors to buy into a diversified selection of bonds with an investment
much lower than would be needed to buy a portfolio of individual bonds.
So which bond investments are right for your portfolio? That's a question for you
and your financial advisor to answer together. But knowing about some of the
options beyond Treasuries is the first step to building the diversified bond portfolio
that can help you pursue your short- and long-term investment goals.
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