What Is a Bond Portfolio?

Types Of Bonds

Bonds fall into four main categories: government bonds, municipal bonds, corporate bonds and mortgage bonds. Federal bonds tend to pay the lowest interest rates but are also viewed as the safest bonds. Municipal bonds are issued by state and local governments and usually pay higher returns than federal bonds. Corporate bonds tied to major companies are viewed as relatively conservative investments while bonds issued by smaller, less-established firms are higher risk but pay better interest rates. Mortgage-backed bonds tend to have the highest rates but are also the most volatile, since these bonds are tied to mortgages and lose value when borrowers default on the underlying loans.

When you establish a bond portfolio, you can either concentrate on buying certain types of bonds or diversify your portfolio with a mixture of government, corporate and mortgage-backed bonds. If a bond issuer defaults on bond payments or goes bankrupt, you stand to lose your investment. Bonds are rated by credit agencies and bonds issued by entities most likely to fall into default are classified as junk bonds. Many investors are wary of junk bonds due to the heightened default risk, but other investors are attracted to the bonds because of the high interest rates junk bonds pay. Many investors keep a mixture of conservative low yield bonds and high yield high risk bonds.

You should keep municipal bonds in a separate brokerage account from your other bonds because interest payments on municipal bonds are usually exempt from federal income tax. Therefore, to retain the tax-exempt status of interest payments, you must hold the bonds in a tax-exempt brokerage account. You cannot keep taxable bonds such as corporate or federal bonds in a tax-exempt holding account. Some municipalities issue bonds that are tied to joint public and private projects, and these bonds are taxable and belong in a taxable brokerage account.

Interest rates on bonds change due to a variety of economic factors, and people who buy long-term bonds issued at low rates often find that bond interest payments do not keep up with inflation over the long-term. Bonds are issued with term times ranging from six months to 30 years. Most financial advisers recommend buying bonds with a variety of durations so that every year you have some bonds maturing, which you can reinvest in newly issued bonds while your other bonds continue to produce income. If you constantly buy bonds, you are less likely to miss out on periods when bonds are issued with above-average interest rates.