If you’re a stock investor looking to branch out into other asset classes, bonds are likely high on your list. After all, stocks and bonds are a classic pairing—like peanut butter and jelly. When combined in the right proportions and tailored to your preferences, they can offer a more balanced and potentially stronger portfolio than either asset alone.
However, just as there are many varieties of stocks, bonds come in different types too. Below, we’ll explore the primary categories of bonds, provide some pros and cons of each, and address key questions to help you shape your bond investment strategy.
What is a bond?
A bond is basically a loan you give to a government, company, agency, or city. In return, a bond is designed to provide you with regular interest payments based on the bond’s stated rate, and when it reaches maturity, you get back the bond’s face value—typically $1,000 per bond.
Bonds are generally seen as less volatile and less risky than stocks, especially when held to maturity, making them a useful tool for portfolio diversification. But they still involve risks. An issuer can default, which may lead to loss of principal. Bond returns can also fall behind inflation, reducing your purchasing power. And if interest rates rise, bond prices usually drop—creating risk for investors who might need to sell before maturity.
Types of bonds
When you look at different kinds of bonds, you’re really looking at the kinds of borrowers behind them. Since each borrower comes with a different level of risk, the bonds they issue can vary a lot in their interest rates, how easy they are to trade, and even how they’re taxed.
Government bonds (US)
When people refer to government bonds, they usually mean US Treasury securities—bonds, bills, notes, and TIPS—issued by the Treasury. These are often called Treasurys. Backed by the full faith and credit of the US government, they’re considered very low risk when held to maturity, though this typically means lower yields compared to other bonds.
Pros:
- Very low risk of default or losing principal
- Highly liquid and easy to trade
- Interest is exempt from state and local income taxes
Cons:
- Generally, offer lower yields than other types of bonds
International government bonds
Besides US government bonds, investors can also buy bonds from foreign governments. The risks and potential returns can vary a lot from country to country. In general, bonds from nations with stable economies and strong credit ratings are considered safer and usually offer lower yields, while bonds from less developed or more politically unstable countries tend to offer higher yields due to the added risk.
Pros:
- Provides diversification beyond US government bonds
- May offer higher yields than Treasurys
Cons:
- Higher risk of default and potential loss of principal
- Exposure to currency exchange-rate fluctuations
- No state or local income-tax exemptions
Agency and GSE bonds
Agency bonds are issued by certain US government–related agencies, like the Federal Home Loan Banks and Federal Farm Credit Banks, and are considered low risk because of this backing. They’re usually a bit harder to trade than US Treasurys, so they tend to offer slightly higher interest rates. Their interest is also typically exempt from state and local taxes.
GSE bonds, such as Fannie Mae and Freddie Mac, are issued by government-sponsored enterprises (GSEs), which are semi-private companies supported by the federal government. Unlike federal agencies, these bonds are not fully government-backed, and their interest is usually taxable at the state and local level. As a result, GSE bonds often offer higher interest rates than agency bonds.
Pros:
- Can offer higher yields than Treasurys
- Generally, considered low risk
- Some agency bonds may be exempt from state and local income taxes
Cons:
- Not as easy to buy or sell as Treasurys
- Some (like GSE bonds) may carry a slightly higher risk of default or losing principal
- Certain GSE bonds may not offer state and local tax breaks
- Some may be called early, meaning the issuer can pay them off before maturity
Municipal bonds
Municipal bonds (munis) are issued by states, cities, counties, and towns to help pay for public projects like building schools or fixing roads. Although they’re backed by the local government that issues them, defaults can happen—though they’re uncommon—which means munis generally carry a bit more risk (and offer higher yields) than Treasurys or agency bonds. The interest you earn from most municipal bonds is exempt from federal income tax, and if you live in the state that issues the bond, it may also be exempt from state and local taxes.
Pros:
- May offer higher yields than Treasurys and agency bonds
- Interest is typically exempt from federal income taxes
- May also be exempt from state and local income taxes if you live in the issuing state
Cons:
- Higher risk of default and potential loss of principal compared with Treasurys and agency bonds
- Some municipal bonds can be called early, meaning the issuer pays them off before maturity
- Municipal bond tax breaks generally don’t apply in a tax-advantaged retirement account
- Generally, less liquid than Treasurys and agency bonds
Corporate bonds
Corporate bonds are issued by companies to help fund things like daily operations, expansion plans, or new projects. Because these bonds rely on the company’s financial strength, they usually involve more risk than government, agency, or municipal bonds. But the level of risk can vary a lot depending on the company’s credit rating and overall stability.
Corporate bonds with lower credit ratings usually pay higher interest rates due to the added risk that the issuer might not be able to repay its debt.
Pros:
- Often offer higher yields than Treasury, agency, and municipal bonds
- Generally easier to buy and sell than agency or municipal bonds
Cons:
- Higher risk of default and potential loss of principal compared with Treasurys, agency bonds, and municipal bonds
- Credit quality varies widely, so some companies may carry significant financial risk
Junk bonds
Some companies, financially stressed cities, and certain foreign governments with lower credit ratings can still issue bonds. Because there’s a greater possibility they might not repay their debt, these bonds offer higher interest rates to attract investors. They’re often called high-yield bonds, junk bonds, speculative bonds, or non-investment-grade bonds. Their prices can also move sharply when credit ratings change—downgrades often trigger sell-offs as investors see more risk.
Pros:
- Chance to earn much higher yields than other types of bonds
Cons:
- Higher risk of default and potential loss of principal
- Some may be called early, meaning the issuer pays them off before maturity
- Often harder to buy or sell compared with other bond types
How to choose the right bond for you
If you decide to incorporate bonds into your portfolio, it’s important to practice diversification—just as you would with stocks or any other asset class. In choosing which types of bonds to invest in, you should consider your:
Risk tolerance
Because different types of bonds carry different levels of risk—default risk, credit risk, inflation risk, etc.—you need to know how much risk you are comfortable taking on. Investors with low risk tolerance may gravitate more toward Treasurys, while those with higher risk tolerance may be willing to take on the greater risk of corporate and even junk bonds.
Income needs
How much income you need—and how much money you have to invest—will shape the level of yield you should look for in your bond portfolio. If you need more income but have less money to invest, you may need to consider higher-yield bonds to reach your goals—but keep in mind that higher yields usually come with higher risk and a greater chance of losing money.
Liquidity concerns
Do you intend to hold your bonds until maturity, or is there the possibility that you would need to sell before that time? Not all bonds have the same level of liquidity as others. Municipal bonds and junk bonds, for example, can sometimes be illiquid, limiting your ability to sell on the open bond market.
Tax situation
Depending on your tax situation, you may decide that certain bond types can help you lower your burden of income taxes. At the same time, if you are subject to the alternative minimum tax (AMT) these tax benefits may be muted—offering fewer benefits for the increased risk you are taking on.
How to buy bonds
Buying bonds is usually a straightforward process, just like buying stocks.
- Open an investment account: This can be a brokerage account, retirement account, custodial account, HSA, or any other type of investment account.
- Evaluate your options: Consider which types of bonds align with your needs, and whether you want to purchase individual bonds or bond funds for easier diversification.
- Fund your account and buy: Deposit money into your account and purchase the bonds or bond funds that you have selected.
- If you’re working with a financial advisor or wealth manager, they can also help you purchase bonds that fit into your broader financial plan.
Choosing the right bond mix depends on your goals, risk comfort, and time horizon. By focusing on what matters most to you, you can select the bonds that best support your overall investment strategy.