Bonds are an important part of the global economy because they allow governments and corporations to borrow money at the best rate available with structured terms for repayment. They also give investors the opportunity to secure stable, predictable returns on their investments with very little risk. Read on to learn more details about how to invest in bonds.
What Are Bonds?
A bond is a loan. When you buy one, you are loaning money to the issuing organization in exchange for interest. There are different types of bonds.
- Municipal bonds are issued by city, state and local governments
- Corporate bonds are issued by businesses
- Treasury bonds are issued by the federal government
- Foreign bonds include debt sold by governments and corporations outside the U.S.
There are a few key pieces of information any investor must know before considering a bond purchase. The first is the bond’s date of maturity. A bond matures when it reaches its set repayment date and the issuer pays back the principal — or the amount you initially invested. The value paid at maturity is also called the par value.
The second important figure to know is the yield, which is the annual interest rate (like the APR on a credit card). Most bonds are sold at par value and pay interest through coupon payments, usually issued every three or six months. A $1,000 bond with a 10 percent yield would pay $100 a year in two $50 payments. Some bonds might have variable rates that will change over time, but most offer a fixed rate that pays the same yield year in year out.
Most bonds are given a rating by one of the major rating agencies that express how stable the group issuing the bond is. One of the main risks of owning bonds is the potential that the bond issuer defaults.
This is very rare for most bonds, but understanding just how likely it is can be essential to know what a good yield is for the investment. The greater the risk, the higher the potential return usually is.
These ratings are just like the credit scores. Bond ratings can range from AAA-rated “investment grade” bonds, usually issued by extremely large, stable governments or corporations, to C- or D-rated “junk” bonds, which come from iffier issuers but typically offer better yields to attract investors despite the risk. In general, bonds are a safe investment with a guaranteed return.
How to Invest in Bonds
You can invest in bonds through a brokerage firm, including most online trading platforms or mutual fund companies, but it frequently requires a larger initial investment or account minimum to get started than investing in stocks.
You can buy bonds directly from the company or municipality, but many individual investors prefer the simplicity and functionality of a bond fund.
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How Do You Buy Bonds?
One of the simplest ways to invest in bonds is to buy them directly through your broker. You can shop what bonds are being issued in the near future and select the ones that best fit your desired returns and risk profile. Or you can shop for bonds sold on the secondary market, where you’re buying bonds that were already issued by another investor.
Brokerage firms exist mainly for the purpose of facilitating purchases just like this for investors of all stripes. Many may include advisory services to help you select the bonds that are best for you. They will charge a transaction fee, though, for making a purchase.
What Is a Bond Fund?
Bond funds operate on the same principle as an exchange-traded fund or stock mutual fund. The fund manager will select bonds that fit the prescribed criteria of the fund and then sell individual shares in the fund to investors. You can invest in bond funds through most brokerage firms or fund management companies.
Bond funds are usually much more accessible for investors, allowing them to buy a slice of a large, diversified basket of bonds without having to do the careful research typically required to select each bond individually. What’s more, bond funds typically offer individual shares at more manageable prices.
Bond funds might include fees paid to the managing company. Those fees, often called an expense ratio, can make a significant dent in your returns over time, so be careful to compare expense ratios, yields and performance of bond funds before selecting one.
Bond funds also don’t “mature” like bonds bought directly, meaning that they’re subject to shifts in value based on the secondary bond markets and interest rates, which can make them riskier in some ways than purchasing bonds directly.
Investing in Bonds for Beginners
Knowing what the top bonds to invest in are can be difficult, but any investor can take the time to learn about bonds and start investing. There are, however, some basic things you should understand before starting.
Market Value vs. Par Value
The market value of a bond is what someone would be willing to pay for that bond in the present. Depending on what the yield on the bond is, how far it is from maturity and what the prevailing interest rates are, a bond might have a market value that is above or below its par value.
Aside from the risk of default, the other major risk associated with investing in bonds is changing interest rates. When the Federal Reserve changes interest rates, it tends to have a ripple effect on the economy. When interest rates go up, newer bonds will have higher yields and older bonds become less valuable. The opposite is true when interest rates fall.
For most investors who are buying and holding bonds to maturity, a loss of market value won’t make a difference in their returns, which only depend on the yield and par value.
Holding vs. Trading
Bond markets can be very volatile, with plenty of speculators willing to gamble on how changing interest rates and market dynamics might shift prices. If you choose to buy and sell bonds on the secondary market, you’re treating your bonds like most people do stocks and probably won’t reduce your risk by much.
Most individual investors stocking their 401k or IRA, though, are buying and holding to maturity. Bonds have a set par value and income stream that won’t change no matter what’s happening with the markets, making them almost entirely risk-free in many cases.
Stocks vs. Bonds
Bond markets and stock markets tend to move inversely to each other because they are essentially competing for investment dollars. When bond yields are up, they can draw people away from riskier stocks, and when they’re down, the bigger returns offered by stocks will be more attractive.
When investing in bonds, it’s important to understand this dynamic. In particular, when stock markets are highly volatile, investors will rush to move money from stocks to bonds — boosting the value of the later significantly.
Your investment horizon is the length of time that you expect to hold your portfolio. It plays an important factor in deciding what sort of mix of stocks and bonds is most appropriate.
Stocks often offer higher returns over time. However, they are also more chaotic, rising and falling in value unpredictably. If you have a long-enough investment horizon, you can gladly accept these short-term shocks until the market rebounds. Someone who is rapidly approaching retirement won’t have as much slack to absorb a market crash, however.
As such, bonds become more preferable the closer someone gets to retirement and the shorter his investment horizon becomes. This is the case because bonds offer fixed returns that aren’t susceptible to market volatility.
A bond ladder refers to a method for staggering the maturity dates of a bond. It spreads out risk and provides a regular repayment of your investment principal — which has major advantages for investors.
If you have $20,000 to invest in bonds over the next 20 years, you could simply buy one bond with a par value of $20,000 and a maturity date in 20 years. However, that would mean you won’t have access to any of that $20,000 until the bond’s maturity date. When you really need short-term funds, you may be forced to sell the entire bond, exposing yourself to risks on the secondary markets.
If you split your $20,000 across 20 different bonds that mature in each of the next 20 years, the annual repayments of $1,000 could waterfall back into your portfolio in addition to your regular interest payments, allowing you to either extend your ladder by reinvesting or using that cash for other investments.