5 types of bonds to invest in for diversification

Investing insights

Financial professionals recommend diversifying your investment portfolio as it can help mitigate the risks that uncertainty and volatility creates.

A common diversification strategy is to allocate part of your portfolio to fixed-income investments, such as bonds, in order to balance higher-risk investments, such as equities. “When growth assets like stocks don't do well, bonds can kick in and act as a smoothing mechanism over time,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management.

However, not all bonds are equal. “Some investors think that if they load up on high-yield bonds, they’re diversified, but that’s not the case,” Haworth says. While these types of bonds can add value to a portfolio, they’re often as volatile as stocks and may not provide the balance investors are seeking to achieve.

5 types of lower-risk bonds

If you’re looking to diversify without increasing instability, consider bonds with a lower risk profile. Haworth suggests choosing from the following options.

  1. Government bonds. These are issued by stable governments with strong militaries and powers of taxation, including the U.S., Germany, Japan and Canada. U.S. government bonds are called Treasury bonds (T-bonds).
  2. High-quality municipal bonds. Also called muni bonds, these are backed by taxes and revenues from state and local jurisdictions. Focus on general obligations of well-funded jurisdictions or bonds from essential services such as water and sewer revenues. Income from most of these bonds is not subject to federal income taxes as well as in certain states and municipalities.
  3. Highly-rated, high-quality corporate bonds. Look for major companies with diversified product offerings and a long track record of stability and success. Interest earned from corporate bonds is taxable, but they generally offer higher yields than government or municipal bonds.
  4. High-quality, mortgage-backed security bonds. Also known as mortgage-backed securities or MBS, these bonds are secured by both commercial and residential property mortgages and can be good choices for diversification.
  5. Agency bonds issued by government-sponsored enterprises (GSEs). Organizations such as Fannie Mae and Freddie Mac provide credit and other financial services to the public and function as quasi-government entities. However, it should be noted that bonds issued by GSEs are not backed by the federal government and subject to both credit and default risk.

As always, these decisions ultimately boil down to risk management. If you’re looking to maintain the stability of your portfolio for unforeseen events, different types of lower-risk bonds may help you achieve that goal.

Before making any decisions on asset allocation, review your portfolio strategy with a financial professional. Consider timelines, financial goals and desired level of risk – and remember that goals don't change just because the market is in flux.

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Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer's ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Investments in mortgage-backed securities include additional risks that investors should be aware of, such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments.