Bond Basics: 7 Types of Bonds Explained

NEW YORK (TheStreet) --Any bond's single most important characteristic is the entity that issued it, since as an investor you're counting on that issuer to return your money.

There are seven main issuer categories:

1. Treasury bonds;
2. other U.S. government bonds;
3. investment-grade corporate bonds (high quality);
4. high-yield corporate bonds (low quality), also known as junk bonds;
5. foreign bonds;
6. mortgage-backed bonds; and
7. municipal bonds.

Which one do you want? That depends first of all on your tax bracket. If your tax bill is big enough, it will be worth your while to diversify your stock portfolio with municipal bonds, whose yields are lowest, but for a very good reason: The interest payments are exempt from federal income taxes.

If munis aren't for you, your choice of a taxable category depends on your risk tolerance. Broadly speaking, if you want to hold only as much fixed-income as you need to diversify your stock portfolio, stick with Treasuries, governments or investment-grade corporates. There are important differences between the three, but you don't need more than one to be diversified, according to Steve Lipper, senior vice president of Lipper Analytical Services.

As for the other types, you can't count on them to protect you against downturns in stocks. Case in point: In the third quarter of 1998, when the S&P 500 lost 10.0%, the average long-term Treasury fund, the average U.S. government fund and the average corporate fund investing mostly in high-grade bonds all returned more than 3.6%, according to Lipper Analytical Services. Meanwhile, riskier corporate funds returned less than 2%, the average high-yield fund lost 7.2% and the average emerging market fund lost 27.5%. Other foreign debt funds held up better, and the various classes of mortgage-backed funds didn't do badly; still, these are complicated investments that aren't meant to fill the bond portion of your asset allocation.

Here's what you need to know about each of the seven classes of bonds:

1. Treasury bonds

Treasuries are issued by the federal government to finance its budget deficits. Because they're backed by Uncle Sam's awesome taxing authority, they're considered credit-risk free. The downside: Their yields are always going to be lowest (except for tax-free munis). But in economic downturns they perform better than higher-yielding bonds, and the interest is exempt from state income taxes.

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2. Other U.S. government bonds

Also called agency bonds, these bonds are issued by federal agencies, mainly Fannie Mae(FNM) (the Federal National Mortgage Association) and Ginnie Mae (the Government National Mortgage Association). They're different from the mortgage-backed securities issued by those same agencies, and by Freddie Mac (FRE) (the Federal Home Loan Mortgage Corp.). Agency yields are higher than Treasury yields because they are not full-faith-and-credit obligations of the U.S. government, but the credit risk is considered minimal. Interest on the bonds is taxable at both the federal and state levels, however.

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3. Investment-grade corporate bonds

Investment-grade corporates are issued by companies or financing vehicles with relatively strong balance sheets. They carry ratings of at least triple-B from Standard & Poor's, Moody's Investors Service or both. (The scale is triple-A as the highest, followed by double-A, single-A, then triple-B, and so on.) For investment-grade bonds, the risk of default is considered pretty remote.

Still, their yields are higher than either Treasury or agency bonds, though like most agencies they are fully taxable. In economic downturns, these bonds tend to underperform Treasuries and agencies.

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4. High-yield bonds

These bonds are issued by companies or financing vehicles with relatively weak balance sheets. They carry ratings below triple-B. Default is a distinct possibility.

As a result, high-yield bond prices are more closely tied to the health of corporate balance sheets. They track stock prices more closely than investment-grade bond prices. "High-yield doesn't provide the same asset-allocation benefits you get by mixing high-grade bonds and stocks," observes Charles Schwab Chief Investment Officer Steve Ward.

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5. Foreign bonds

These securities are something else altogether. Some are dollar-denominated, but the average foreign bond fund has about a third of its assets in foreign-currency-denominated debt, according to Lipper.

With foreign-currency-denominated bonds, the issuer promises to make fixed interest payments -- and to return the principal -- in another currency. The size of those payments when they are converted into dollars depends on exchange rates.

If the dollar strengthens against foreign currencies, foreign interest payments convert into smaller and smaller dollar amounts (if the dollar weakens, the opposite holds true). Exchange rates, more than interest rates, can determine how a foreign bond fund performs.

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6. Mortgage-backed bonds

Mortgage-backeds, which have a face value of $25,000 compared to $1,000 or $5,000 for other types of bonds, involve "prepayment risk." Because their value drops when the rate of mortgage prepayments rises, they don't benefit from declining interest rates like most other bonds do.

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7. Municipal bonds

Municipal bonds -- often called "munis" are issued by U.S. states and local governments or their agencies, and they come in both the investment-grade and high-yield varieties. The interest is tax-free, but that doesn't mean everyone can benefit from them.

Taxable yields are higher than muni yields to compensate investors for the taxes, so depending on your bracket, you might still come out ahead with taxable bonds.

More on Bond Investing: Bond Basics | Municipal Bond Formulas

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