When I hear the word "bond," I think "007." So when my financial advisor first mentioned the option of investing in bonds, I was embarrassed to admit I know nothing about the different types of bonds or how they work. Here’s what I have learned since then, and here's hoping it may help you with your investment strategy too!
In essence, a "bond" is a loan you make to another entity, such as a bank or a company. In exchange for accruing interest (your "return on investment"), you agree to loan your funds to the bank or other entity for their use.
Bonds are considered to be lower risk (but not risk-free) when compared with mutual funds and stocks—so if you’re just starting to build your investment portfolio, including some bonds to balance out risk is a good strategy.
Bonds also have fixed terms and fixed interest rates. The name of a bond denotes the length of time it’s held before it "matures" (this means it will accrue no further interest because the term of your loan to the entity has expired and they now owe you your principle back, plus interest).
Bond term lengths by name
- Bills: Bills are bonds that mature in less than 12 months.
- Notes: Notes are bonds that mature between one and 10 years.
- Bonds: Bonds are, well, bonds that mature in more than 10 years.
Luckily, when it comes to bonds, you really only need to learn a few new terms.
- Par: The face value of the bond at the time of maturity.
- Coupon: The interest the bond pays (ex: a $1,000 bond with a 5% coupon pays $50 in interest upon maturity).
- Duration: Although it sounds like this means time to maturity, it really means sensitivity to market fluctuations. The longer the duration, the more sensitive the bond will be to fluctuations in the interest rate.
All about treasury bonds
In addition to different names for different term lengths, there are different types of bonds. You can choose to invest in just one type, or in more than one type. Risk rates vary, so it can be a good idea to have more than one type of bond in your portfolio.
The best-known type of bond is often called by its nicknames, "T-bills" or "savings bonds." When you were a child, perhaps you received a savings bond as a gift from a relative. Because T-bills are fully secured by the "full faith and credit" of the U.S. government, they are considered a near-zero-risk investment. However, in exchange for the lower risk, you will reap a lower interest rate in your return.
There are several types of treasury bills, and each works a bit differently:
- Treasury bills: The maturity rate ranges from a few days to 6 months. You buy them at a percentage off face value and they "mature" (you redeem them) at full face value. For example, you might buy one of these bonds for $950 and it matures at $1,000.
- Treasury notes: Treasury notes give you the option of a 2-year, 5-year, or 10-year maturity date. You can also purchase them in $1,000 increments.
- Treasury bonds: Treasury bonds mature in 30 years, 60 years, etc., and they pay interest every 6 months until maturity.
- Treasury inflation-protected securities: Nicknamed "TIPS," these bonds are sold in 5, 10, or 20 year maturity dates. Their main purpose is to protect your overall investment portfolio against valuation inroads from inflation.
- Savings bonds: There are two types of savings bonds, EE and I Savings. You have various options for purchasing either, but only I Savings bonds are indexed to offset inflation.
How to buy Treasury bonds
You can buy Treasury bonds from your bank or broker, or you can visit TreasuryDirect.gov. You can also buy them on the open exchange like any other investment vehicle.
Other types of bonds
These additional types of bonds are not secured by the U.S. government, so they’re considered to be higher risk than Treasury bonds. However, they still offer a lower level of risk than mutual funds or stocks.
- Municipal bonds: Nicknamed "Munis," municipal bonds are loans you make to local, city, and state governments. The nice thing about these bonds is that they are exempt from federal and state income tax. Some Munis offer insurance, so check before you buy.
- Corporate bonds: Here, you’re loaning your money to a corporation, so your level of risk jumps from moderate to very high. Be sure to do your homework before purchasing corporate bonds!
- Agency bonds: Risk-wise, agency bonds fall right in between Treasury and Corporate bonds. They’re issued by various government-sponsored entities, yet they’re not insured by the U.S. government.
- Zero-coupon bonds: These bonds don't make payments via coupons, but rather are issued at a discount off face value, and pay out their full value at maturity.
How to save on buying bonds
Most brokers will require you to buy at least $5,000 in bonds before they will assist you. Even if your broker agrees to a lesser amount, be wary if they tell you they take no commission on the sale (they do—by marking up the bond price!).
The best route to buying bonds is to do so through your bank or online via TreasuryDirect.gov. This way, you pay no commission up front and also reap the full value of the bond at maturity.