Bonds are typically less volatile than stocks and some other investments. They’re also a popular way for investors to produce income from their portfolios. Learn what you need to know to start investing in bonds.
How To Buy Bonds
If you’re interested in buying bonds, there are a few paths you can take.
Through a Broker
If you have a brokerage account, you can purchase bonds through your broker. You can use your broker to purchase bonds on the secondary market from other investors. In some cases, you can purchase bonds directly from the issuer. Buying bonds through your broker means searching the market for the bonds that are available. You then can choose how much you’d like to invest. Place a purchase order and you can buy the bond. You’ll then start receiving the interest payments.
Directly From the Government
The U.S. government issues many different types of bonds, with maturities ranging from weeks to decades. You can buy bonds directly from the government using the website TreasuryDirect. You can use the site to invest in savings bonds or buy other types of government securities such as Treasury bills or notes.
Through a Mutual Fund or ETF
Many mutual funds and exchange-traded funds (ETFs) focus on investing in bonds. If you want to easily build a diverse portfolio of bonds, buying shares in one of these funds might be a good option. “Investing in funds gives you many advantages, including broad diversification, professional management, competitive bond prices (often called a tight bid-offer spread), automatic reinvestment of interest payments, and reinvestment of matured bonds,” said Henry Gorecki, a Certified Financial Planner and Principal at Chicago-based HG Wealth Management LLC. According to Gorecki, another advantage of bond funds is access to bond investments that ordinarily would not be available to individual investors.
Decide Which Bonds To Buy
There are many types of bonds. Each has different characteristics surrounding things such as potential risk, interest rates, and tax treatment, so the bonds you choose will depend on your financial goals.
U.S. Government Bonds
U.S. government bonds are issued directly by the U.S. Department of the Treasury. They are among the safest bonds available, which means they will not carry the highest interest rates. However, if you want the safest investment possible, they can be strong choices.
Municipal Bonds
Municipal bonds come from state and local governments as well as U.S. government agencies. They typically are a relatively safe investment but offer higher rates than U.S. government bonds.
Corporate Bonds
Corporate bonds come from private and public companies that want to raise money through borrowing. Like individuals, corporations have credit ratings determined by companies such as Standard and Poor’s, or Moody’s. The interest rate of a corporate bond will typically depend on the credit rating of its issuers. Companies with stronger credit pay lower rates.
High-Yield or Junk Bonds
High-yield bonds, also called junk bonds, are bonds from organizations with low credit ratings. This means there is a greater risk of default, which could result in investors losing money. To compensate for that risk, the bond issuer must offer larger interest payments. That makes these bonds suitable for investors who are willing to accept greater risks for higher returns.
Understand the Risks of Buying Bonds
There are a different risks investors must consider when buying bonds:
Credit risk: Credit risk is the most basic type of risk. A bond issuer may find itself unable to make its required payments, meaning you lose out on interest and your principal. Inflation risk: Inflation causes the purchasing power of money to drop. If inflation rises, the interest payments you receive from a bond become worth less. If inflation rises by too much, you could lose purchasing power by buying bonds. Interest rate risk: Bonds usually have fixed rates, but market interest rates rise and fall all the time. If you buy a bond with a low rate, and rates rise, you’ll be locked into an investment at a lower interest rate. Also, higher rates lead to lower bond prices. Liquidity risk: When you buy a bond, there are only two ways to get your money back: wait for the bond’s duration to elapse, or sell it to someone else. If you can’t find a buyer, you might be waiting years until you get your money back, which can be an issue if you find yourself in a financial emergency. Call risk: Some bonds are callable, meaning that the issuer can choose to repay the principal ahead of schedule. If you lock in a bond at a high rate, the issuer might call it and pay off the bond early, so you won’t earn as much interest income as expected.
What You Need To Know Before You Buy Bonds
Before you start buying bonds, it’s important to understand the basics of how they work.
Duration
The duration of a bond is the length of time you must wait before the bond issuer returns the principal used to buy the bond. For example, if you buy a $1,000 bond with a duration of 10 years, you’ll receive interest payments for 10 years. After 10 years pass, you’ll receive your final interest payment plus the $1,000 you initially invested. Generally, bonds with longer durations have higher interest rate risk since there’s a greater possibility of interest rate changes over a long time period.
Credit Ratings
Bond issuers receive credit ratings that aim to describe the risk of default. These ratings usually range from a low of D to AAA, depending on the rating agency issuing the rating. The lower the credit rating of a bond, the higher the risk of investing in it. However, bond issuers typically compensate for that risk by offering higher interest rates.
Fees
Some brokers charge fees for investing in bonds depending on the type of bond you buy, whether you buy it directly from the issuer or if you require your broker’s assistance to carry out the transaction. For example, you might have to pay $1 per bond you purchase on the secondary market through Charles Schwab online, but you may have to shell out $25 if it’s a broker-assisted trade. For a new bond issue, there is no fee for using Schwab because the issue price already includes the broker’s selling concession. If you invest in bond funds, those funds will carry an expense ratio, which is a fee you pay to invest in the fund. For example, if a fund has a 0.25% expense ratio, you will pay $2.50 per year in annual fees for every $1,000 you have in the fund.
Interest Rates
Interest rates change over time and they can impact your bond investments. When the Federal Reserve raises its fed funds rate, interest rates in the markets move up. If you bought a two-year bond before interest rates started going up, your bond will continue to pay the lower interest rate, while newer bonds would pay higher rates. Also, as interest rates go up, bond prices go down, which means your investment is also worth less. Lower bond prices affect bond funds, too, dragging down their net asset value and lowering the fund’s overall return. “The drawbacks are an immediate reflection of losses when interest rates rise… . But, of course, the opposite is true when interest rates fall. You also have to factor in the investment expenses of the fund,” said Gorecki.
Primary vs. Secondary Market
You can typically buy a bond from two sources: directly from the issuer or from another investor. If you buy from the issuer, you’re buying on the primary market. You typically pay the face value for the bond and can hold the bond until maturity or choose to sell it for someone else. If you buy a bond from another investor, you’re buying on the secondary market. On the secondary market, a bond may trade for more or less than its face value depending on the bond’s interest rate and market rates. You also have to pay attention to the maturity date of the bond because you may be purchasing it many years after it was initially issued.
Pros and Cons of Buying Bonds
Pros Explained
Generate income: Bonds come with regular interest payments. If your goal is to generate income from your portfolio, bonds can be an easy way to do so. For example, if you have a $1 million portfolio and know you want to generate $40,000 per year, you can do so by investing in bonds with an average interest rate of 4%. Less risk: Bonds are generally less risky than stocks and other securities. You can add them to your portfolio to reduce its volatility and lower your investment risk. Clear ratings: Bonds have clear credit ratings, allowing you to buy bonds that match your risk and return desires.
Cons Explained
Lower returns: Historically, a portfolio of bonds has generated lower overall returns than one composed of stocks. That means you pay a price for reducing your risk.Long-term holding risk: Many risks related to bond investments are due to their long-term nature. Inflation and interest rate risk can be major issues if you buy a long-term bond.Lower liquidity: If you buy individual bonds, they’re typically less liquid than stocks, making it harder to get your money back if you need to.
Should I Invest in Bonds?
Bonds can be a good investment for many people. They’re popular both with older investors looking for safety and income as well as younger investors looking to temper the volatility of the stocks in their portfolios. However, they might not be the best choice for people seeking the highest possible return. “When designing portfolios for my clients,” Gorecki said, “I tend to use funds for younger clients since they are more interested in total return and are not too concerned about the immediate return of principal. However, for older clients, the peace of mind of knowing exactly when they can expect their principal back is often more critical.”
