Types of Bonds and Their Risk Profiles

Just like stock portfolios, fixed income (bond) portfolios vary in their focus. There are various types of bonds. The most common way to classify them is as follows:

• Government and supranational bonds

• Investment-grade corporate bonds

• High-yield corporate bonds

• Yearlings

Government bond portfolios invest in the debt issues from national treasuries or other government
agencies. These investments tend to have low risk and low returns because of the financial stability
of national governments. In the UK, bonds are also known as gilts: this comes from the bonds being
very low risk, or “gilt-edged”. Supranational bonds are issued by institutions such as the European
Investment Bank (EIB) and the World Bank. As with government bonds, they have very low risk.
Investment-grade corporate bond portfolios invest in the debt issued by companies with high credit

These credit ratings are issued by rating companies like Standard & Poor’s. They rate
debt based on the likelihood that a company will meet the interest obligations of the debt. The returns
and risks of these investments vary along this rating spectrum. Many corporate bond portfolios invest
in company debt that ranges the entire continuum of high-grade debt.

Types of Bond

In contrast to investment grade debt, high-yield corporate debt, also called “junk bonds”, is the debt
issued by smaller, unproven, or high-risk companies. Consequently, the risk and expected rates of
return are higher. (Junk, or high-yield, is defined as a bond with a Standard & Poor's ratings below BBB.
Yearlings invest in the debt issued by local authorities and agencies, such as public school systems. The
favourable tax treatment on these types of investments makes them a favourite of tax-sensitive investors.
Yields also tend to be higher than for central government bonds as the risk is considered greater.

Other types of bonds include index-linked bonds. The capital redemption of this type of bond is linked
to the rate of inflation. As a result, index-linked bonds are more popular in times of high inflation.
Convertible bonds are also quite popular with investors. These bonds can be exchanged for shares
or other securities, usually with the company that issued the bond.

Investment managers also manage bond portfolios that mix together the different types of bonds.
Indeed, hybrids of all kinds exist. Typically, though, if you have a lot of money, a better way to diversify
is to invest in a fund made up of one type of bond. If, for example, you’ve got £100 million to invest,
you’re likely to give £10 million to the best yearling fund manager, £10 million to the best corporate
bond fund manager, etc., rather than invest all $100 million in a hybrid.