Bonds are an important part of the economy because they let governments and corporations borrow money at attractive rates with structured terms for repayment. They also let investors secure stable, predictable returns on their investments with very little risk. You can invest in bonds by buying individual bonds or bond funds. There are two main ways to make money from your investment: holding onto them until their maturity date or selling them at a price higher than the initial investment.
Whether you’re a new bond investor or you’re exploring options for updating your portfolio, it helps to understand what bonds are, how they work and how they react to market shifts.
Read on to learn more about how to invest in bonds:
- What Are Bonds?
- What Investors Need to Know About Bonds
- Are Bonds Good Investments?
- Bond Ratings
- How to Invest in Bonds
- How Do You Buy Bonds?
- What is a Bond Fund?
- Investing in Bonds for Beginners
A bond is a loan. When you buy one, you’re loaning money to the issuing organization in exchange for interest payments. What follows are the different types of bonds and their characteristics:
- Agency bonds can be issued or guaranteed by U.S. federal government agencies or by government-sponsored enterprises.
- Corporate bonds are issued by businesses to raise money for acquisitions or capital expenditures.
- International bonds include debt sold by governments and corporations outside the U.S.
- Municipal bonds are issued by city, state and local governments to fund new schools, roads and other community-oriented projects.
- Savings bonds issued by the U.S. Department of the Treasury are available in denominations as small as $25.
- Treasury bonds are issued by the federal government and can be traded on the bond market like other bonds.
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There are a few key things all investors should 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 — 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% 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 and year out.
Other important features investors should consider are security, callability and liquidation preference. Like other types of loans, bonds can be secured or unsecured. Secured bonds have assets backing them in the event the issuer cannot pay the bondholder. They carry less risk than unsecured bonds, which don’t have collateral backing them.
Some bonds never reach maturity. For instance, callable bonds give the issuer the right to pay back the loan at any time. When this happens, investors lose out on the interest they might have earned. Another risk is liquidation preference in bankruptcy. In this scenario, the issuing company pays back debts in a specific order, which could leave some investors empty-handed.
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Most bonds are given a rating by one of the major rating agencies to gauge the stability of the group issuing the bond. The biggest risk is that the issuer defaults. This is very rare for most bonds, but understanding the likelihood of it happening is essential to determining whether the yield is worth the risk. In most circumstances, the greater the risk, the higher the potential return.
Bond ratings are like credit scores. They can range from AAA-rated “investment grade” bonds — which are usually issued by large, stable governments or corporations — to C- or D-rated “junk” bonds, which come from much less stable issuers but typically offer better yields to attract investors. As a general rule, bonds are usually a safe investment with a guaranteed return.
You can invest in bonds through entities such as brokerage firms, online trading platforms and mutual funds. But these typically require a larger initial investment or account minimum to get started than if you were buying stocks. You can also buy bonds directly from the issuing company or government entity. However, many individual investors prefer the simplicity and functionality of a bond fund.
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One of the simplest ways to invest in bonds is to buy them directly through your broker. You can shop around for bonds being issued shortly and select those that best fit your desired returns and risk profile. Or, you can shop for bonds sold on the secondary market, where you’ll purchase bonds that were already issued by another investor.
Brokerage firms mainly exist to facilitate purchases for investors of all stripes. Many provide advisory services to help you select the bonds that are best for you. They’ll charge a fee for this service, however, and in some cases also charge a transaction fee when you make a purchase.
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Bond funds operate on the same principle as exchange-traded or mutual funds. 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.
A bond fund is usually much more accessible for investors because it lets them buy a slice of a large, diversified basket of bonds without having to do the research typically required to select each bond individually. What’s more, bond funds usually offer individual shares at more manageable prices.
The downside is that bond funds might include fees paid to the managing company. Those fees, sometimes called expense ratios, can make a significant dent in your returns over time. Be sure to compare expense ratios, yields and bond fund performances before selecting one.
Bond funds also don’t “mature” the way bonds that are bought directly do, meaning they’re subject to shifts in value based on the secondary bond markets and interest rates. This can make them riskier in some ways than purchasing bonds directly.
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Knowing the best bonds to invest in can be difficult, so take the time to learn about bonds before investing. It’s important to familiarize yourself with a few 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 it in the present. A bond might have a market value that is above or below its par value, depending on the bond’s yield, how far it is from maturity and the prevailing interest rates.
Aside from the risk of default, the other major risk associated with investing in bonds is changing interest rates. Bonds have an inverse relationship with interest rates, meaning that bond prices rise when interest rates fall and decline when interest rates rise. Several factors affect this relationship.
Can You Lose Money Investing in Bonds?
Lower interest rates make bonds less appealing than other types of investments because they offer lower returns, so in that sense, you might “lose” money that could have been earned elsewhere. Also, issuers might call in the bond before it reaches maturity, meaning the bondholder loses out on the potential income. As interest rates rise, bonds become more attractive.
During a recession, bonds typically do not lose value or depreciate at the same rate as more volatile investments. This doesn’t make them immune to the effects of an economic downturn, however. When the Federal Reserve changes interest rates in response to economic trends, it can have a ripple effect that might lead to a lower return on your investment.
For most investors who are buying and holding bonds to maturity, a loss of market value won’t make a difference in their returns.
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. This probably won’t reduce your risk by much.
Most individual investors stocking their 401(k)s or IRAs with bonds 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.
Stocks vs. Bonds
Because bond and stock markets are essentially competing for investment dollars, they tend to move counter to each other. When bond yields are up, they can draw people away from riskier stocks. When bond yields are down, the bigger returns offered by stocks will be more attractive.
It’s important to understand this dynamic when investing in bonds. For example, when stock markets are volatile, investors often rush to move money from stocks to the safety of bonds — boosting the value of the latter significantly.
Your investment horizon is the length of time that you expect to hold your portfolio. It plays an important role in determining the best mix of stocks and bonds.
Stocks often offer higher returns over time. However, they are also less stable, 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. But someone who is rapidly approaching retirement age won’t have as much slack to absorb a market crash.
Bonds become more attractive as investors move closer to retirement and have shorter investment horizons because they offer fixed returns that aren’t as susceptible to market volatility.
The method of staggering the maturity dates of a bond is referred to as a bond ladder. It spreads out risk and provides a regular repayment of your investment principal — which has major advantages for investors.
For example, 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 need short-term funds, you might 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 go back into your portfolio along with your regular interest payments. This lets you either extend your ladder by reinvesting or use that cash for other investments.
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This article has been updated with additional reporting since its original publication.