Among the major asset classes, U.S. bonds have long been a staple for those seeking stability and income. Indeed, bonds have historically served as an effective counterbalance to stocks, which tend to be more volatile in nature.
Because they make regular interest payments and mature at par value, a bond’s return stream is often more predictable, helping to smooth the ride for long-term investors. Yet despite their unique features, bonds have just as many complexities, making them somewhat more difficult to understand than stocks.
In this article, we’ll explore four primary types of investment-grade U.S. bonds: treasuries, corporate bonds, MBS & ABS, and municipal bonds, and the role each plays in a diversified portfolio.
Table of Contents
What Is a Bond?
A bond represents a loan made by an investor to a borrower, such as a corporation or government. In return for the loan, the borrower agrees to pay the investor periodic interest payments (the coupon), until the bond matures. At maturity, the borrower returns the bond’s face value (the principal) to the investor.
Investors generally classify bonds by sector, credit rating, and maturity. Each classification offers insights into a bond’s behavior and potential risk-reward profile.
- Sector. This describes the issuer of the bond, such as a government, agency, or corporation. Each sector has unique risk and reward characteristics.
- Maturity. This refers to the length of time until an investor receives the bond’s principal. Bonds can be short-term (maturing in less than 3 years), intermediate-term (3-10 years), or long-term (more than 10 years). In general, the longer the maturity, the more sensitive the bond is to interest rate changes.
- Credit Rating: Agencies like Moody’s, S&P, and Fitch provide credit ratings for bonds, which reflect the issuer’s ability to pay back the debt. Bonds with higher ratings (AAA to BBB or equivalent), also known as investment grade bonds, are relatively safer than bonds rated BB and below. These bonds, sometimes referred to as high yield or junk bonds, come with higher risks but also potentially higher yields.
Understanding the Risk-Reward Trade-Off
By nature, bonds tend to be less risky than stocks. However, each type of bond comes with a unique risk-reward trade-off.
For instance, investors worldwide view U.S. Treasuries as one of the safest investments available given their near-zero default risk. Yet historically, treasuries have generated modest returns compared to riskier fixed income securities.
For example, as of June 30, 2023, the ICE U.S. Treasury 1-3 Year Index, a benchmark for short-term treasuries, has generated an average annual return of 0.75% over the last 10 years. Meanwhile, the Market iBoxx USD Liquid Investment Grade Index, a benchmark for investment-grade corporate bonds, has generated an average annual return of 2.93% over the same period.
Generally, the higher the risk of a bond, the higher its yield or potential return. So, while corporates may offer greater upside potential than treasuries, they also have a higher chance of defaulting since they’re subject to the financial health of the issuing companies.
Common Types of U.S. Investment-Grade Bonds:
U.S. Treasuries
The U.S. Treasury market accounts for roughly 40% of the total U.S. bond market—the largest bond market in the world. At the end of 2022, there were $23.9 trillion worth of marketable U.S. treasury securities outstanding, according to Statista.
The federal government issues U.S. Treasury bonds to raise funds for a variety of governmental purposes, including the financing of the national debt, infrastructure projects, and other public needs. Since treasuries are backed by the full faith and credit of the U.S. government, investors view them as one of the safest investments available.
Treasuries are also highly liquid with a deep secondary market. Thus, investors can generally trade them readily with reliable price transparency.
Treasury notes have maturities of two, three, five, seven, or 10 years and make coupon payments every six months. In contrast, treasury bills have a maturity of one year or less, whereas treasury bonds have a maturity of 30 years.
Treasuries tend to perform well during periods of economic uncertainty, as investors consider them a safe-haven investment. But while treasuries offer relative safety and predictable income, they aren’t completely risk-free. Treasuries—especially long-term treasury bonds—tend to be sensitive to interest rate changes and typically offer modest yields compared to other types of bonds.
Corporate Bonds
Corporate bonds are debt securities issued by private corporations. Unlike treasuries, the risk-return profile of a corporate bond is heavily dependent on the issuer and its financial health.
Maturities for these securities can range from very short to very long, and credit ratings vary based on the creditworthiness of the issuing corporation. Thus, careful research and due diligence are essential when investing in corporate bonds.
Corporate bond prices tend to be sensitive to changes in corporate health and economic conditions. As a result, they typically perform best in strong economic environments where companies are more likely to meet their debt obligations.
Because they’re inherently riskier than treasuries, corporate bonds offer the opportunity for higher yields than government securities. Yet they also come with a higher risk of default and may not be as liquid as treasuries.
Mortgage-Backed Securities (MBS) & Asset-Backed Securities (ABS)
Mortgage-Backed Securities (MBS) represent an interest in a pool of mortgages. Agencies such as Ginnie Mae, Freddie Mac, and Fannie Mae are the most common issuers of MBS.
Asset-Backed Securities (ABS) are like MBS, but the underlying assets vary. For instance, you may own an interest in a pool of car loans or credit card receivables.
Since MBS and ABS investors receive interest payments from a pool of assets, their income can remain relatively stable even if some of the underlying loans default. However, these securities come with unique risks, making careful selection and oversight essential.
For instance, MBS and ABS are subject to prepayment risk—the risk that borrowers will pay back their loans early. If interest rates drop, for example, homeowners may refinance their mortgages or car loans, paying off the old ones and impacting the bond’s income stream.
In addition, MBS and ABS performance is often closely tied to the general health of the economy and lending market. Consequently, a booming housing market may bode well for MBS, and vice versa.
As part of an investor’s bond allocation, MBS and ABS offer diversification benefits, as well as the potential for attractive yields. Yet given the complex nature of these bonds, they may not be appropriate for everyone.
Municipal Bonds
Municipal bonds (munis) are debt securities issued by states, cities, counties, and other public entities to finance public projects like schools, highways, and bridges. Munis come in two types: general obligation (backed by the full faith and credit of the issuer) and revenue (backed by specific revenue sources).
Municipal bonds are unique in that their interest payments are usually tax-free at the federal level. In some cases, they may also be free from state and local taxes.
In addition, munis generally offer more stability in a portfolio than corporate bonds or MBS and ABS. However, because they’re subject to the financial health of the issuing municipality, the risk of default, while low for investment-grade municipal bonds, still exists.
Constructing a Diversified Bond Portfolio
Constructing a diversified bond portfolio is a delicate balance between risk and reward. As such, holding a variety of bonds can stabilize returns over time, leading to a smoother investment journey.
However, diversification means something different for every investor. Indeed, the right mix of bonds depends on your financial goals, investment horizon, and risk tolerance.
At the same time, your fixed income portfolio is unlikely to remain static over time. Bonds mature, interest rates fluctuate, and the economic landscape is cyclical. Not to mention, your goals, investment horizon, and risk tolerance may also shift.
Therefore, maintaining the right level of diversification is essential for mitigating risk. But, having the flexibility to adjust your allocation and capitalize on near-term opportunities as they arise can further enhance your investment results over the long run.
Milestone Asset Management Group Can Help Construct a Diversified Portfolio Tailored to Your Individual Goals
When it comes to investing in fixed income securities, factors like interest rates, the economic environment, the health of the issuer, and your individual investment goals and risk tolerance all play an important role in the selection process. Since each bond type offers a unique set of opportunities and risks, it’s crucial to understand these nuances before investing.
By working with a fee-only financial advisor like Milestone Asset Management Group, you can benefit from our expert resources, including ongoing investment management and portfolio oversight.
Our team of experienced financial professionals can help you design a personalized investment plan tailored to your financial needs and objectives. Contact us today to discover how we can support you in safeguarding and growing your hard-earned wealth, guiding you toward to your financial goals.
