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 less risk than the stock market.
You can invest in bonds by buying individual bonds or bond funds. However, there are important differences between the two, and it’s important to understand them as an investor.
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.
What Are Bonds?
A bond is a loan. When you buy one, you’re loaning money to the issuing organization in exchange for interest payments. Here are some of 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 are backed by the full faith and credit of the U.S. government.
What Investors Need To Know About Bonds
The most important characteristics of a bond from an investment perspective are its maturity and its yield.
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. For most bonds, par or maturity value is $1,000.
Some bonds never reach maturity. For instance, callable bonds give the issuer the right to pay back the loan at certain specified times before maturity, often for a premium price. When this happens, investors have no choice but to give up the bond in exchange for the promised payment.
A bond’s yield is its annual interest rate divided by its current price.
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 5% yield would pay $50 a year in two $25 payments. However, if you were able to buy that bond on the open market at $900 instead of $1,000, its current yield would rise to 5.6%. Most bonds offer a fixed rate that pays the same yield year in and year out.
What Are the Risks of Investing in Bonds?
Although there are a number of risks associated with investing in bonds, two of the biggest are interest rate risk and credit risk.
Interest Rate Risk
Interest rate risk refers to how bond prices trade down when interest rates rise. This is because investors are less willing to buy your 5% bond if current market interest rates are 6%.
If you invest in a bond fund, you should be aware that there is no maturity date at which you’ll receive a return of your principal. Maturing bonds are continually reinvested by fund managers, so no principal is returned to investors. Thus, bond funds are subject to more interest rate risk than individual bonds, which have prices that will eventually trend towards maturity value.
Credit risk refers to the chance that the bond issuer will default and not make its promised principal and interest payments. Many bonds carry ratings issued by third-party agencies to help investors gauge the risk of default.
Are Bonds a Good Investment?
Whether or not bonds are good investments depends on your risk tolerance and financial goals.
Bonds are generally considered defensive investments, as they return principal to investors at maturity. They are also called income investments, since they make regular interest payments. Bonds are therefore generally a good investment for those looking for a safe, steady investment that provides income, as opposed to the growth offered by the more volatile stock market.
Within the general asset class of bonds, however, there is a wide variety of investment options. Treasury securities are generally considered the safest investments, but they pay low yields. So-called high-yield bonds carry a much higher risk of default but pay significantly higher yields as compensation.
Thus, even within the asset class of bonds, investors can choose more aggressive or more conservative options.
How To Invest in Bonds
You can buy bonds in a number of different ways: Individual bonds directly from banks, brokerage firms or the U.S. Treasury directly.
Mutual funds are sold by a variety of financial services firms, including fund companies themselves. Exchange-traded funds can be bought directly on the stock exchange via a broker.
Individual bonds often have a $5,000 or $10,000 minimum, and some funds require at least $1,000 to invest. But exchange-traded funds typically have no minimum — you may even be able to buy fractional shares of some ETFs.
Investing in Bonds for Beginners
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.
Bonds have an inverse relationship with interest rates, meaning that bond prices rise when interest rates fall and decline when interest rates rise.
Can You Lose Money Investing in Bonds?
If you sell an individual bond before maturity, you’ll receive the market price, which may be higher or lower than the par value.
Bond funds have no maturity date, so if interest rates rise and remain high, you may never receive the full amount you invested, although you will continue to receive interest payments. A bond that defaults could also cause you to lose the amount you originally invested.
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.
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.
The Bottom Line
Can you get rich off of bonds? Although some professionals do trade bonds, you typically won’t use bonds as a way to get rich.
Rather, bonds offer a defensive, generally conservative way to preserve your principal while earning interest. But there are so many different ways you can invest in bonds, you should consult your financial advisor before taking the plunge.
Joel Anderson contributed to the reporting for this article.