Which bond is the best?

To be clear, we won’t be discussing who is the best James Bond of all time today. Everyone knows it’s Sean Connery anyway. Rather, we’ll be discussing the pros and cons of the four most common types of bonds. This debate will be far more valuable to your financial life, but perhaps not as lively as the perennial argument over who was the best 007 of all time.

Bonds are a portfolio foundation

In an earlier Lionomics post, we first introduced the quiet, calming power of bonds. They’re a fundamental building block of a balanced investment portfolio and the perfect complement to fiesty stocks. With stocks as well as bonds, you have thousands of individual investments to choose from. But while public stocks are all structured relatively similarly, bonds come in many varieties, each of which has unique characteristics.

For many investors like you, the basic types of bonds to know are:

  • US Treasury bonds (T-bonds)
  • Municipal bonds (munis)
  • Corporate bonds
  • High-yield bonds

Let’s dive into the pros and cons of each bond type and finish up with further proof that ETFs are an investor’s best friend.

US Treasury bonds offer low risk, low interest rates

Treasury bonds are issued by the United States Treasury and are backed by the full faith and credit of the US government. Sounds secure, right? They are. Treasury bonds are less risky than even other types of bonds, which may help cushion against volatility in a portfolio. However, with their lower risk may come lower rewards. Treasury bonds often offer lower interest rates than riskier bonds.

Of course, Treasury bonds are not completely risk-free. While their interest and principal payments are backed by the government, the price of Treasury bonds can still go up and down with the market. It’s also helpful to know that interest earned on all US Treasury bonds is exempt from taxation at the state and local level but is fully taxable at the federal level.

Municipal bonds offer tax benefits

Municipal bonds, often referred to as munis, are issued by local governments (such as a town, county, or district). Unlike Treasury bonds, munis are not backed by the federal government, making them somewhat riskier. But that slightly increased risk means that they also tend to pay higher interest rates. Munis can be backed either by the general taxing authority of the local government issuing them (these are called “general obligation munis) or by revenue from a specific project (these are called “revenue munis”).

Additionally, munis have added tax benefits. For example, the interest paid by muni bonds is free from federal taxes, and there can be local tax benefits as well. Munis can be a great tool for generating income and managing taxes, but it’s important to consult an expert when deciding if they’re appropriate for your portfolio.

Because munis offer income tax-free on the federal level, they’re generally inappropriate to place within tax-advantaged retirement vehicles like IRAs because, in those vehicles, it makes more sense to use the tax advantage for bonds offering higher yields.

Corporate bonds offer higher risk, higher interest rates

Unlike Treasury bonds and munis, corporate bonds are issued by companies rather than governments. As such, bondholders accept the risk that a company may not be able to repay this type of debt if, for example, its business sours (this would be credit risk) or there is a downturn in the economy (this would be systemic market risk). In return for taking on higher risk, corporate bondholders receive higher interest rates – the level of which is determined by many factors, including the company’s credit rating.

A company’s corporate credit rating gives you an idea of the company’s ability to pay its creditors (including its bondholders). There are three main providers of corporate credit ratings, and each agency has its own ratings system. Corporate bonds issued by companies with the best credit ratings are often referred to as “investment grade” or “high grade,” because investors can feel fairly confident that the company can repay its debts.

High yield or junk bonds are just plain risky

Corporate bonds issued by companies with lower credit ratings are often referred to as “high yield bonds” or, in less flattering terms, “junk bonds.” These bonds are often considered to be “speculative” in nature, but may potentially serve a valuable purpose in a portfolio because of their higher interest payments. Note: A speculative investment is one with a high degree of risk where the investor is focused on price fluctuations. In this case, the investor would be hoping that either the junk bond issuer could somehow dramatically improve its performance and get a higher credit rating, thus driving up the value of the bond significantly, or that it could remain solvent (i.e., able to pay its debt) for long enough to make all of the principal and interest payments on the outstanding bond.

ETFs are an ideal way to invest in bonds

Managing a portfolio of bonds can be tricky. Not only are there thousands of bonds to research and keep track of, there are also interest payments and maturing bonds to manage and reinvest. Thus, most investors prefer to use mutual funds and exchange-traded funds (ETFs) as a way to invest in bonds because they offer convenience, simplicity, and generally low fees.

Buying a bond ETF allows you to add a diversified set of bonds to your portfolio quickly and easily. In most cases, investors choose to invest in bond funds to generate income or to balance other parts of the portfolio, which in turn reduces the overall risk of holding only stocks. Turns out that a bond ETF might just be the best Bond of all time.