Which Type of Bond Is Safest?
Which Type of Bond Is Safest?
A bond is a loan an investor makes to an organization in exchange for regular interest payments over a specific period of time. At the end of that period, known as its maturity date, the loan is repaid in full. A key differentiator as to whether a bond investment is safe or risky depends on to whom the loan is made.
Treasuries are considered the safest bonds available because they are backed by the “full faith and credit” of the U.S. government. They are quite liquid because certain primary dealers are required to buy Treasuries in large quantities when they are initially sold and then trade them on the secondary market. Treasuries also are more affordable than other types of bonds; you can buy one for as little as $100. Investors can purchase Treasuries through brokerage firms, banks or the Treasury Direct website.
A treasury bond with a maturity of one year or less is called a Treasury bill, or T-bill. A maturity between two and 10 years is a Treasury note, or T-note. The term Treasury bond generally refers to long-term maturities of 10 to 30 years from their issue date.
Other types of government bonds include those issued or guaranteed by U.S. federal government agencies and those issued by government-sponsored enterprises, which are corporations created by Congress for public use. GSEs include the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage (Freddie Mac) and the Federal Agricultural Mortgage Corp. (Farmer Mac). Agency bonds are backed by the U.S. government, but GSE bonds do not enjoy quite the same guarantee and therefore pose greater credit risk.
Next on the bond risk spectrum are municipal bonds (muni bonds), which are issued and guaranteed by individual states, cities, counties and other government entities. These bonds use loan funds to build roads, schools and other public projects. The guarantee for muni bonds is made by the issuer, so while they are relatively secure because they come from government issuers, their level of risk varies depending on the financial stability of the backing agency.
Next on the risk spectrum are corporate bonds, which are issued by all types of companies in order to raise money for capital expenditures, operations and acquisitions. They work just like government bonds and, should the issuer claim bankruptcy before the principal is repaid, bondholders are positioned toward the front of the line for at least a partial repayment. Corporate bonds are generally categorized as either investment grade or non-investment grade, which refers to how risky they are. Investment grade bonds are generally lower risk, but non-investment grade bonds – also referred to as high yield or junk bonds – tend to pay out higher interest to compensate for that risk.
While global diversification can be a good risk mitigation strategy for some investors, international bonds are considered more risky than domestic bonds, and emerging markets bonds are considered the most risky. Because these bonds are issued by foreign governments and companies, the risk varies by issuer and is impacted by political, cultural, environmental and economic factors. Furthermore, foreign bonds expose investors to currency risk, which means the value of payments can fluctuate once funds are converted to U.S. dollars.
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