Factors to Consider When Selecting a Bond

Investors looking to add bonds to their portfolios face a trade-off: The safest government bonds typically pay very low yields, while higher-yielding corporate bonds are more prone to default.

As a rule, high-yield corporate bonds come with more risk. On the other end of the spectrum are U.S. Treasury bonds, which are generally considered to be one of the safest investments around.

So how can investors decide which bonds to add to their portfolios?

Three popular types of bonds include corporate, municipal, and U.S. Treasury. Of the three, high-yield corporate bonds generally represent the most aggressive investment and Treasury bonds the least aggressive.

The difference in the credit quality of the bond issuers certainly plays a role, but other factors can influence bond yields as well. A company issuing high-yield corporate bonds typically won't have as strong a track record or as strong financials as a firm that can issue an investment-grade corporate bond. Investment-grade bonds are rated "BBB" or better as designated by Standard & Poor's.

During times of uncertainty, the difference in investment-grade bonds versus lower-rated bonds becomes increasingly obvious, which is why it's important for investors to do their own research when considering which bonds to add to their portfolio.

In addition to prevailing interest rates, the yields for a municipal bond depend on the financial condition of the issuing authority and whether the bonds are insured. With various exceptions, interest paid on municipal obligations is generally not subject to federal taxes. U.S. Treasury bonds, besides being considered safest from default, aren't taxable at the state or local level. As previously mentioned, corporations issue bonds, and their yields depend on the company's perceived financial strength.

During times of market and economic uncertainty, investment-grade bonds can quickly be downgraded, and their value can fall dramatically, which is why it's important to know what you're buying.

But it's difficult to know for sure which corporations or municipalities can weather a prospective financial storm and come out in good shape.

Aggressive investments, such as high-yield bonds, aren't for everyone. But during low-interest rate environments, their yields can look lofty.

Still, chasing yield is never a good idea without understanding that it comes with added risk. Look at the rating and read the ratings agency reports, and if you do go down the credit scale to obtain yield, understand the risk you're taking.