Investment Strategies for Different Bond Types
If you’re considering diversifying your portfolio, investing in bonds is a good way. Bonds are debt instruments an entity(Government, Corporations, Municipalities, etc.) issues to meet its capital expenditure.
For instance, the Government might need funds for education facilities, infrastructure development, healthcare facilities, public safety, etc. Corporations might need to borrow bond funds for mergers and acquisitions, research and development, extension into new markets, etc.
When you buy or invest in a bond, you lend money to the entity/issuer in exchange for periodic interest payments within a specified period. The issuer pays the lender the principal amount when the bond reaches maturity.
1. Government Bonds
Government bonds are debt instruments issued to finance government spending, manage day-to-day operations and regulate the money supply. Anytime the government needs funds for any project, they invite the public to buy bonds. The government pays the principal and interest, observing the clauses in the bond. Government bonds are mostly considered safe and low-risk investments, which is why they offer low interest rates.
In the United States, the government provides various bonds with diverse maturities through the country's treasury, where some of them give regular interest payments.
U.S. Savings Bonds
A U.S. savings bond is a type of debt security issued by the government to its citizens to sponsor federal expenditures, providing them with moderate returns. These bonds are exempt from local and state income taxes; they are non-negotiable and cannot be transferred easily.
Pros
- They are backed by the U.S. government, which makes them safe.
- They are not affected by market fluctuations.
Cons
- The returns are low compared to other investment options.
Treasury Bonds
Treasury Bonds or T-bonds are long-term bonds with a maturity period of 10-30 years. These bonds offer interest payments bi-annually and repay the principal amount on maturity.
Pros
- Long-term stability.
- Suitable for investors who need a safe investment with high yields.
Cons
- Lower interest rates when compared to other options.
Treasury Notes
Treasury Notes or T-Notes are intermediate-term bonds with a 2-10 years maturity period. Like Treasury bonds, they offer fixed interest bi-annually, and the principal amount is repaid on maturity.
Pros
- Great for investors who want a shorter-time commitment.
- Liquid securities.
Cons
- Susceptible to the risk of inflation.
- Its conservativeness can slow the growth of an investment portfolio.
Treasury Bills
Treasury bills or T-bills are short-term bonds with one year or less maturity periods. Unlike other government bonds, they are sold during auctions and do not offer periodic interest.
Pros
- Highly liquid securities with an available market of buyers and sellers.
- Yields are more competitive than most short-term investments.
Cons
- Unavailability of regular interest payments.
Treasury Inflation-Protection Securities (TIPS)
TIPS are government bonds that protect investors from the harmful effects of inflation. The principal value readjusts with fluctuations in the Consumer Price Index. TIPS have a maturity period of 5, 10 and 30 years.
Pros
- Protect against inflation.
- Promotes investment portfolio diversification.
Cons
- They may not protect against deflation.
2. Municipal Bonds
Municipal bonds are debt securities that municipal, local and state governments issue to finance public projects, obligations and day-to-day operations. When you purchase municipal bonds, you lend money to the bond issuer to get interest payments. Municipal bond interests are exempt from federal income tax and, sometimes, state and local taxes if you live in a state where the bond is issued. Investors can get municipal bonds directly via primary offerings or participate in secondary markets. In the primary market, investors can buy bonds directly; in the secondary market, they can buy or sell already-issued bonds before they mature.
Pros
- Exempt from federal income tax and sometimes local and state tax.
- Volatility is low.
Cons
- Market prices of bonds could drop.
3. Corporate Bonds
A corporate bond is a debt security that corporations issue to raise funds for different purposes. The proceeds from corporate bond sales can be used to buy stock, purchase new equipment, fund mergers and acquisitions, invest in research, etc.
The investor gets periodic interest payments at a variable or fixed interest rate. When the bond matures, the principal investment is returned to the investor. Corporate bonds are considered riskier than other types of bonds, and they mostly have higher interest rates to make up for this risk.
Pros
- Higher interests than government bonds and other investments.
- They can diversify and balance your investment portfolio.
Cons
- The bond’s market value can fall during inflation.
4. Mortgage Bonds
A mortgage bond is a type of bond commonly backed by real estate and property for investment purposes. Investors who buy a mortgage bond are protected because a valuable asset secures their principal investment.
If the mortgage bondholders default in payment, they could sell the asset to compensate for their inability to pay the investors. Due to this intrinsic safety, mortgage bonds are mostly safer than corporate bonds. Mortgage bonds might be lower than corporate bonds because the former undergoes securitization, which makes them safer investments.
Pros
- Less creditworthy individuals can access significant capital.
- Bonds can be securitized into derivative instruments.
Cons
- Collateral is lost when the borrower defaults on payment.
5. Green Bonds
Green bonds are fixed-income instruments that are marked out for environmentally friendly projects. These bonds share similarities with traditional options like best bond ETFs, corporate bonds, etc., but are specifically for projects that benefit the environment.
These projects include fishery, forestry, energy efficiency, clean water, renewable energy, etc. Sometimes, Green bonds have tax incentives that attract investors. Green bonds are held to high international standards to ensure trustworthiness and transparency.
Conclusion
Investing in bonds is one of the profitable ways to preserve your funds and earn a decent return. You can consider using bond investments as a steady income source from the regular interest payments.
Before buying any bonds, do your due diligence to ensure the one that aligns with your needs. Weigh the pros and cons of each bond investment, and consult with a financial expert to determine which bonds to invest in and how to navigate your investment strategy.
Read on to learn all about the best savings account that will net you the most profit.