For many investors, talking about bonds is about as interesting as watching paint dry. They aren’t nearly as interesting as stocks. But if you have a portion of your portfolio allocated to bonds—or plan to—it’s a topic worth some discussion.

The bond market is actually much larger and much more diverse than the stock market. For most investors, though, there are just a few types of bonds to consider. We can examine each in turn.

Perhaps the most well known type of bond investment is a total-market fund. All major fund providers, including Vanguard (ticker: BND) and iShares (ticker: AGG), offer funds tracking the total-bond market index. The key advantage of funds like this is that they’re broadly diversified, holding a mix of U.S. Treasury bonds, for stability, and corporate bonds, for their higher yields. That’s why many people see this as the easiest and best way to invest in bonds.

The downside of total-market funds, though, stems from a metric known as duration. A bond’s duration is similar to its maturity and is an indicator of its riskiness. The intuition is that bonds are like IOUs. To the extent that an IOU will be paid back sooner rather than later, it inherently carries less risk. Similarly, bonds that require an investor to wait longer for repayment carry more risk.

More specifically, when interest rates rise, bonds can drop in value. That’s because older bonds, which were issued at lower rates, become relatively less attractive than newer bonds carrying higher rates. When this occurs, bonds with longer durations experience larger declines. The problem with total-market funds is that their average duration is relatively long, and this makes them risky.

We saw this most notably in 2022, when the Federal Reserve hiked interest rates in an effort to tamp down inflation. Total-market funds lost about 13%. While that type of loss wouldn’t be unheard of in the stock market, this is not what investors expect from bonds. For that reason, while you might have some allocation to a fund like this, I generally avoid them.

What alternatives are there to total-market funds? You could opt for a fund that holds high-quality corporate bonds. These are bonds issued by large, solid companies like Microsoft and Bank of America. These carry two potential advantages over total-market funds: First, there’s the potential to earn more, since, on average, companies have to offer higher coupon rates than the government in order to entice buyers.

Also, when you move away from total-market funds, you can break free from the duration risk described above. Funds like Vanguard’s short-term corporate bond ETF (ticker: VCSH), for example, carry much shorter durations. That’s why funds like this fared much better in 2022, losing less than 6%.

Despite these advantages, corporate bonds aren’t ideal, because they carry another type of risk: They tend to be positively correlated with the stock market, meaning that they often move in unison. That’s the opposite of what an investor would want. We saw this dynamic most recently in the spring of 2020. In the early days of Covid, when the S&P 500 dropped more than 30%, corporate bonds sank as well. Even short-term corporate bonds lost more than 10%. In contrast, short-term Treasury bonds gained in value.

That brings us to the next category of bonds you might consider: those issued by the federal government. As you might guess, U.S. Treasury bonds have historically been the most secure. With arguably only one exception, the U.S. government has never missed a bond payment. That’s why finance textbooks will refer to Treasurys as the “riskless asset.” And that’s why Treasurys would always be my first choice. But we should be careful about seeing them as truly riskless. There are two situations in which even Treasury bonds can pose risk.

First, Treasurys carry duration risk, just like any other bond. In 2022, intermediate-term Treasurys lost more than 10%, and long-term Treasurys lost nearly 30%. The solution? You might weight your holdings toward short-term issues. In 2022, short-term Treasurys lost an almost insignificant 4% of their value.

The second risk with Treasurys is harder to quantify, and that’s the risk posed by Congress. More than once in recent years, the political parties have come to a stalemate in budgetary debates, and that’s taken us uncomfortably close to the so-called debt ceiling, beyond which the government might not have been able to pay its bills, including payments to bondholders.

How real is this risk? It’s hard to say, and personally, this is not a risk I worry a lot about. The reality, though, is that there’s a first time for everything. That’s why you might consider diversifying beyond Treasurys into what I see as the next best thing: state and local government bonds, also known as municipals.

Municipal bonds are similar to Treasurys in that many cities and states have the authority to levy taxes, helping ensure that they’ll always have the funds available to make payments to bondholders. That makes municipals—in general—relatively low-risk. But two significant caveats apply: First, the municipal market is very diverse, and while some bonds are backed by tax-collecting entities, others are not. And sometimes even seemingly safe municipal entities can face financial stress.

In 2020, at the outset of Covid, the New York City subway system saw ridership fall 92%. If the Federal Reserve Bank of New York hadn’t provided billions in emergency funding, the transit authority would have defaulted on its bonds.

Another way in which municipal bonds carry more risk than Treasurys: In colloquial terms, the federal government can print money. It’s more complicated than that, but the idea is that it would be very difficult for the Treasury to truly run out of money, and that’s why no municipal bond can ever be considered as secure as a Treasury bond. Taking a step back, though, highly-rated municipals rarely default, and especially if you stick with short-term issues, the risk is very low.

Municipal bonds carry another unique characteristic: They are exempt from federal tax. And if you live in the state where a bond was issued, it’ll be free of state tax as well. In exchange for this benefit, though, the coupon payments on municipal bonds are generally lower than on comparable Treasurys. For those in marginal tax brackets over 30%, though, the tax savings can offset those lower coupon rates.

There are many other categories of bonds. For most investors, though, it doesn’t need to be more complicated. To build a balanced portfolio, you might consider a simple mix of four Vanguard funds: Short-Term Treasury (ticker: VGSH), Short-Term Tax-Exempt (ticker: VTES), Intermediate-Term Treasury (ticker: VGIT), and Short-Term Inflation-Protected Securities (ticker: VTIP).

For more on this topic, please see: Giving Credit, Navigating the Bond Market and Sea Change.​