Bonds can play a useful role in your investment portfolio, as a source of diversification and a buffer against stock market volatility. The main types include government bonds (federal, provincial, and municipal), corporate bonds (investment-grade and high-yield), foreign bonds, and bonds with special features like convertible or zero-coupon structures. Knowing these categories can help you make more informed investment decisions.
An overview of bonds
A bond is a loan agreement between a bond issuer (such as a government or company) and a bondholder (an investor). When you buy a bond, you're lending money to the issuer, who promises to pay you back with interest.
Governments and corporations issue bonds when they need to borrow money for things like infrastructure or operations. That could be a city's new bridge or a company's research program. Not all bonds are created equal — they come with different risk levels, returns, and features.
How bonds work and how you earn money
When you invest in a bond, you lend money to the issuer for a set period. In return, the issuer pays you regular interest — known as the coupon rate — until the bond reaches its maturity date, when you get your principal back.
Investors make money from bonds in two ways: through regular interest payments, and by selling the bond for more than they paid on the secondary market. Because bond prices move opposite to interest rates, a bond's value can rise if broader interest rates fall.
Types of bonds
Bonds are generally categorised by issuer, credit quality, and special features. These distinctions can help you choose options that align with your financial goals.
Government bonds
Government bonds are debt securities issued by governments to fund public projects and operations. They're considered among the safest investments because governments can raise taxes or, at the federal level, print money to repay bondholders.
The three main types of government bonds are federal, provincial, and municipal.
Provincial bonds
Provincial bonds are issued by provincial governments. They typically offer slightly higher yields than federal bonds because their credit risk can be higher, and credit quality can vary by province.
Municipal bonds
Municipal bonds, or "munis" for those in the know, are securities issued by municipal governments to fund specific projects, such as the construction of a new bridge or improvements to a school.
The two main types of municipal bonds are:
General obligation bonds: backed by the issuer's taxing power and full faith and credit.
Revenue bonds: backed only by revenue from a specific source (for example, highway tolls). Some are structured as non-recourse bonds, meaning repayment depends on that revenue source.
There are also bonds issued by a municipal government on behalf of private groups, such as non-profit colleges or hospitals. But if these organisations can't pay back the original debt, the government isn't responsible for the outstanding amount.
Municipal bonds are relatively safe, but they come with more risk than sovereign government bonds because the issuer is a much smaller entity. Depending on your country and location, you may not have to pay taxes on the income from municipal bonds.
Corporate bonds by credit quality
Companies issue corporate bonds to raise money for expanding operations, buying equipment, or funding research. Because corporations can't tax citizens like governments can, their bonds carry higher default risk and typically offer higher interest rates to compensate.
Corporate bonds are divided into two main categories based on their credit rating.
Investment-grade corporate bonds
Investment-grade corporate bonds have BBB or better credit ratings from agencies like Standard & Poor's (S&P) or Moody's. Key characteristics:
Lower default risk: issued by financially stable companies.
Moderate returns: typically higher yields than government bonds but lower than high-yield bonds.
Credit ratings: typically rated BBB/Baa or higher, which generally indicates a lower risk of default.
Junk bonds
Junk bonds are also called high-yield bonds or speculative bonds. These are corporate bonds with the lowest possible ratings from agencies like S&P or Moody's, meaning the companies are at higher risk of defaulting.
High-yield (junk) bonds are among the higher-risk categories of bonds. They can be more volatile than investment-grade bonds and may behave differently from equities depending on market conditions. They offer interest rates several times higher than government bonds to entice investors.
Foreign bonds and currency risk
Foreign bonds are bonds issued in a domestic market by a foreign issuer. The issuer offers the bond in the domestic market's currency. For example, a Japanese company may issue a bond in the Canadian market using Canadian dollars.
The main challenge with foreign bonds is currency conversion. When you receive interest payments in another currency, you'll pay conversion fees that can fluctuate over time. Make sure these costs don't eat into your returns.
These kinds of bonds are useful for diversifying your portfolio, but they come with some risk depending on the market you're investing in. You also need to consider exchange rate volatility — if the rate moves a lot, it may be unfavourable when you need to sell.
Bonds with special features
While standard bonds pay a fixed interest rate until maturity, some bonds come with unique structures that offer different risks and rewards.
Convertible bonds
A convertible bond is a type of corporate bond that the holder can convert into cash or shares of the issuing company at any time. The number of shares you get when you convert the bond are predetermined.
Convertible bonds offer higher yields than government bonds, but lower yields than conventional corporate bonds. Investors like them because they can turn into stock at pre-set times, letting you capitalise when the share price rises.
Why do companies issue convertible bonds? Several reasons:
Lower interest costs: the conversion feature can allow a lower coupon rate.
Tax-deductible interest: interest payments may reduce taxable income (depending on the issuer and jurisdiction).
Broader investor appeal: may be more appealing for growth companies with lower credit ratings.
Non-conventional bonds
All of the other bonds on this list are conventional because their value, interest payment frequency, interest rate, and maturity date are predetermined. A non-conventional bond is one where those variables can change with time.
For example, zero-coupon bonds don't pay interest every year — the issuers pay all of the bond's interest when it matures. They can be issued by governments or corporations.
These types of bonds are not common for most investors unless you have a very clear understanding of the security and how it fits into your overall portfolio.
Putting bond types to work in a portfolio
Bonds are often used to balance out stock market volatility. Investors use asset allocation to mix different bond types based on their timeline and goals:
Near retirement: if you're saving for retirement, you may prioritise higher-quality government bonds to help preserve capital.
Early career: you may include a limited allocation to high-yield corporate bonds to pursue higher income, with higher risk.
Moderate timeline: you may blend investment-grade corporate bonds with government bonds.
You don't have to buy individual bonds to get this exposure. Many people use bond mutual funds, income portfolios, or exchange-traded funds (ETFs) to quickly gain exposure to a diversified basket of government and corporate bonds. This approach provides broad exposure without the hassle of managing individual maturity dates.
