Buying Bonds: Types of Bonds and How They Work

by SMBX

Note that this article is not an endorsement of any investment strategies or individual types of bonds. You must complete your own research, consult with your financial advisor, and choose products that are right for your financial situation

A bond is essentially a type of IOU. When you buy one, you’re lending the issuer (that is the borrower) a specific amount of money. In exchange for your “loan,” the issuer — which could be a corporation, municipality, or government — promises to pay you a set interest rate over the life of the bond as well as its face value when it matures.

Why invest in bonds, you might ask? Well, for one thing, they can provide a predictable income stream. Many pay out interest biannually — and let’s be honest: Who doesn’t like knowing when they’re getting paid?

Another benefit of investing in bonds is that it preserves capital — when you hold it until it reaches maturity, that is. It also helps to create a more balanced portfolio. At the same time, you’re helping a business, municipality, or government agency by providing it with money that it can use for working capital, debt financing, or its own investment projects.

The thing is, there’s no one single type of bond — there are actually several. Rather than leave you wondering what they are and how they work, we’ve compiled a handy list to help you understand your options.

Government Bonds

Government bonds are issued by the U.S. federal government and backed by a “full faith and credit” guarantee. This means the government promises to fulfill its payment obligation on time. Now, many of us have been burned by a broken promise in the past, but a full faith and credit guarantee is one that the issuer legally can’t break.

When it comes to government bonds, you have a few options:

U.S. Savings Bonds

You may have heard of these before. The U.S. government issues savings bonds that you can buy at a bank, credit union, or the U.S. Treasury Department. Some employers offer them through payroll deductions, too, giving you the option to invest some of what you earn right from your paycheck.

There are two types of U.S. savings bonds:

  • Series I. These bonds come with a fixed interest rate as well as an inflation rate. The inflation rate helps to protect against the rising costs of living (and who doesn’t want that?). Through April 2021, the combined rate is 1.68%.
  • Series EE. These bonds earn a fixed interest rate, and are set up to double your investment in 20 years. Those purchased between November 2020 and April 2021 have an annual rate of 0.10%.

Both are low-risk accrual securities — this means they are set up to earn interest monthly, and that interest is compounded semiannually. You only would get the interest though when you cash in your bonds, so patience will definitely be a virtue here. With either option, you can invest as little as $25 for an electronic bond, meaning you don’t have to break your bank to invest.

Treasury Securities

Treasury securities refer to a few different things:

  • Treasury bills. These are short-term securities that mature in 13 to 52 weeks. They’re also non-interest bearing (so if you’re looking to earn interest, consider the next two options).
  • Treasury notes. Treasury notes are longer-term, maturing in two to 10 years. They are set up to pay interest semi-annually and pay the principal upon maturity. The average interest rate for a 10-year treasury note is around 0.9%.
  • Treasury bonds. Treasury bonds mature in 30 years, with bondholders set to earn interest semi-annually. They are set up to pay the principal back when the bond matures. Interest rates are determined at auction, so they can vary. As of February 2021, the average rate is 1.96%.

While these options are relatively safe investments, rising interest rates could mean the value of your bond declines on the secondary market. Yields may also not keep up with inflation, especially for securities with longer terms. If you’re concerned about inflation, the next option on our list may be more up your alley.

TIPS

The U.S. Treasury offers Treasury Inflation-Protected Securities (TIPS), which are designed to protect against inflation — and with the way things are going, that’s a pretty big incentive. The agency offers these securities with maturity periods of five, 10, and 30 years. The principal gets adjusted semiannually, and your interest payments are based on that inflated principal.

So if inflation continues, the amount you are set to receive increases, even though you have a fixed interest rate. If the adjusted principal is more than your initial investment, you would get the higher amount back at maturity. While these bonds don’t carry an inflation risk, they may have an opportunity risk. In times of low or no inflation (or deflation), they won’t provide as much of a return.

Municipal Bonds

Municipal bonds (“munis”) are bonds issued by states, cities, or counties to raise money for public projects such as building roads, schools, and more. So if you’re all about helping out at the community level, these bonds might be for you. You can choose:

  • General obligation bonds. These bonds aren’t secured, but they do come with a full faith and credit guarantee. The issuer can tax its residents to pay its bondholders if needed. Interest ranges from 0.12% to 0.9%.
  • Revenue bonds. These bonds are backed by the revenue from a specific project. Pay attention to the fine print with these. The issuer may have what’s known as a “non-recourse,” which means you don’t have a claim on the revenue source if it dries up. Average yields range between 0.47% and 2.9%.

One of the major draws to these types of bonds is that the interest you earn generally isn’t subject to federal tax, and it may be exempt from state and local taxes as well. Not having to pay taxes on your earnings sounds pretty great.

These bonds generally have a lower default risk than corporate bonds, but that risk still exists. Investing always comes with risks. They also carry an interest rate risk, meaning that increasing rates could lower the value of your bond on the secondary market.

Corporate Bonds

Corporate bonds are sold by companies to raise money for specific goals. Instead of buying a stake in the company itself, though, you provide a loan with a set term. Corporate bonds are set up to give interest payments, typically twice a year, and the company should repay the principal when the bond matures (the loan term is up).

These bonds typically have a minimum investment of $1,000 and may have either a fixed or variable interest rate. So you do have to be willing to risk a larger chunk of change. Rates vary from one corporate bond to the next, ranging from 1.74% to 4.58%. Risk can also vary from bond to bond, making this factor a little more challenging to determine.

Mortgage-Backed Securities

Mortgage-backed securities (MBS) are bonds secured by real estate and home loans. With these bonds, a bank acts as a middleman between investors and homebuyers. Essentially, you loan money to buyers, but you do it through the lending institution. In essence, you get to help people achieve their dreams of homeownership.

Most mortgage-backed securities are issued or guaranteed by a government-sponsored enterprise such as Ginnie Mae, Fannie Mae, or Freddie Mac. Ginnie Mae’s guarantee is also backed by a full faith and credit guarantee.

An MBS is set up to pay you monthly, and those payments include principal and interest. The current one-year return is 3.44%. You might not receive the same amount each month, so you lose the benefit of predictability. If you’re the kind of person who likes knowing what you’re getting each month, you might want to check out a different type of bond.

One of the biggest risks with these bonds is the “prepayment risk.” The more homeowners prepay their mortgages, the sooner you get your principal back — which sounds good, in theory. What it really means is that you earn less interest, which might not be something you want.

International and Emerging Markets Bonds

Just as you can buy bonds from the U.S. government and companies, you can buy them from international entities, too. These bonds allow you to dip your toes into international markets without ever leaving your home state (or in some cases, your favorite chair).

One thing to keep in mind is that international and emerging markets bonds may come with greater risks. Each country has its own sovereign risk. There’s the risk of default, currency risks, and interest rate risks. While return rates may be higher (ranging from 0.99% up to 7.75%), so is the risk with these types of bonds.

Small Business Bonds™

Small Business Bonds™ are a newer type of bond that allows you to invest in local small businesses, some of which could be those that you frequent in your own community.

Unlike many other types of bonds that require a minimum investment of $1,000 or more, these bonds require a minimum of just $10. You can also earn up to 10% interest.* You could help your favorite local cafe or retailer reach their goals while earning money at the same time. How cool is that?

Not only do Small Business Bonds™ enable you to support your community, but they also make bond investments more accessible to those with little to no experience in investing — $10 is a heck of a lot less than $1,000. They also are set up to pay back monthly with principal and interest, so you don’t have to wait until the full maturity of the Bond to start reinvesting your principal.

As with most other types of bonds, there’s the risk that the business could default on payments. Provided they don’t, you can build and diversify your portfolio, earn money, and help small businesses that you know and love succeed.

Making Your Money Work for You

Bond investments provide a way to make your money work for you while providing capital to the issuer. You can get a predictable income stream and create a more balanced portfolio. Not only that, but holding on to the bond until maturity with no defaults means you get the face value back, plus interest. It can be a nice way to preserve capital, help others, and earn money all at the same time.

*All estimated returns on principal + interests are not guaranteed. The statement is based on the following assumptions: 1) an offering successfully closes and an investor is allocated a Bond or Bonds, 2) that the investor holds their Bonds to maturity and 3) that there are no defaults made by the issuer on any of the Bond payments from issuance to maturity.