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One of the biggest mistakes that young investors make is they put all of their efforts into the stock market—investing only in individual stocks and funds.
In addition to investing in the stock market, it’s also a good idea to purchase other types of financial instruments like bonds.
Investing in the bond market is a great option for all types of investors, from people who are just starting, to people who have been managing personal finance for decades.
Keep reading to learn the bond basics you need to make informed investments in the bond market.
What Is a Bond?
A bond is a fixed income debt instrument between a lender and a borrower. In short, a bond issuer takes money from a lender and agrees to pay it back with interest when the bond reaches maturity.
The period of time until maturity can vary depending on the type of bond that is being issued. For example, some bonds reach maturity in one year while others can last 10 years or longer.
The Benefits of Buying Bonds
There are many reasons why investors should consider purchasing bonds. Here are a few of them.
Bonds can add excellent diversification to a portfolio, offering investors a way to combat volatility during downturns. Bonds can provide steady and consistent returns with fixed interest payments.
Less Risk for Investors
Bonds are considered to be less risky for individual investors and riskier for companies.
During bankruptcy events, bondholders have higher priority than shareholders for liquidation. So if a company goes under, bondholders are paid before common stock owners. Not bad!
In addition, bonds are less volatile than stocks. Bond prices may change according to inflation and the overall economy. But they are more stable investments than stocks, which can significantly rise and fall in value.
Another reason bonds are great is because they often have high interest rates. For example, high-yield corporate bonds have lower credit ratings and, as a result, they offer higher returns for investors.
The Disadvantages of Bonds
On one hand, fixed interest rates offer more security. On the other, they can have diminished returns compared to equity investments. Investing too much of your portfolio in bonds may be too conservative for most early investors. Imagine locking into a low interest bond that matures in 10 years only to see interest rates rise significantly over the next few months. In such a scenario, you’re leaving money on the table.
Not all bonds are protected from inflation. As such, long-term bonds can erode in value, leading to reduced returns for investors.
Bonds are not as easy to liquidate as stocks. Once you invest in a bond, your money is going to be locked up until it matures. While it’s possible to liquidate before maturity, you may have to pay penalties or sell at a lower rate.
If you’re looking to invest in bonds but want liquidity, you may want to look into bond ETFs, which are traded like stocks.
How to Buy Bonds
Now that you have a general understanding of how bonds work, let’s explore how you can go about obtaining them.
Use a Broker
One way to buy bonds is to go through an online broker like Schwab, TD Ameritrade, or Fidelity. When you take this approach, you purchase bonds from other investors who are looking to sell them.
Bonds are not listed on major exchanges. As such, investors must use brokers to arrange bond trades.
You can also purchase United States government bonds directly from the United States treasury via Treasury Direct. Purchasing government bonds directly can enable you to bypass brokers and agents, circumventing fees in the process.
Exchange-Traded Fund (ETF)
In addition to buying individual bonds, you can also purchase bond ETFs, which buy bonds from multiple companies. Funds may have a mix of short-, medium-, or long-term bonds.
Types of Bonds to Explore
If you’re thinking about buying bonds, you need to determine which type of bond makes the most sense for your unique situation.
The Department of the Treasury issues U.S. treasury bonds on behalf of the U.S. government. Since they are backed by the U.S. government, they are considered a very safe and secure investment.
There are multiple types of treasury bonds available from the U.S. Treasury.
Treasury Bill (T-Bill)
T-Bills are short-term securities with varying term lengths. T-Bill maturity dates range from a few days to 52 weeks.
Treasury Note (T-Note)
T-Notes are longer-term securities that mature within 10 years.
Treasury Inflation-Protected Securities (TIPS)
TIPS are bonds and notes with principals that are adjusted based on the Consumer Price Index. These bonds pay interest every six months and mature in periods of five, 10, and 30 years.
Treasury bonds also have longer maturity periods of around 30 years. These bonds pay interest every six months.
Corporate bonds are debt securities issued by public and private corporations. They are diverse, liquid, and have less volatility than stocks.
Investment-grade bonds come with a higher credit rating than corporate bonds. As a result, they are considered to be less risky than corporate bonds.
If you’re looking to maximize your returns from a bond, you may want to consider a high-yield bond. This type of investment has a lower credit rating, making it a higher risk investment than investment-grade bonds.
In addition to buying government bonds from the U.S. government, you can also buy municipal or “muni” bonds from states, counties, cities, and other government entities.
General Obligation Bonds
General obligation bonds are not secured by assets. Instead, they are backed by the faith and credit of the issuer. In some cases, issuers may tax residents to pay bondholders.
Revenue bonds are backed by revenues from specific sources or projects instead of taxes. These can be higher risk. In the event that a revenue stream like a highway toll dries up, bondholders may not be able to claim revenue.
Governments may also issue municipal bonds from private entities, like nonprofit colleges or hospitals.
Tips for Buying Bonds
Even though a bond is relatively secure, it’s still an investment—and all investments carry risk. So before purchasing a bond, understand your risk tolerance meaning what negative effects could happen if the investment fails.
Then, compare the expected return with the risk. If the expected return outweighs the risk, the investment is worth it. If not, you might prefer to leave your money in your bank account and waiting for the next attractive investment opportunity instead.
Letter-based scoring systems are used to judge the quality and trustworthiness of a bond. They can range from AAA to BBB (Standard & Poor’s) and Aaa to Baa3 (Moody’s).
Investing in a bond is a bit like investing in a certificate of deposit (CD) in that your money is locked up for a specific period of time. Bonds have varying maturity dates. Make sure you’re comfortable setting your money aside before you invest in a bond.
Frequently Asked Questions (FAQs)
What Is a Bond Fund?
A bond fund—or debt fund—is a fund that invests in debt securities and bonds. Most bond funds pay frequent dividends that include interest from multiple securities and capital appreciation.
What Is an Exchange-Traded Fund?
An exchange-traded fund (ETF) is a type of fund made of multiple types of securities. An ETF is traded like common stock and usually tracks an underlying index. Vanguard is one company that offers low-cost ETFs.
Are Bonds Riskier Than Stocks?
It depends on a few different factors. For example, in a highly inflationary environment, bonds are considered to be much riskier than stocks. In a moderately inflationary environment, bonds are less risky. And in a market sell-off, stocks are much riskier than bonds.
If you’re thinking about investing in bonds, it’s important to pay attention to how the market and economy is performing. And if you aren’t sure what to buy, consider working with a financial advisor to guide you through the decision-making process.
What Is a New Issue?
A new issue is a stock or bond that’s registered in a publicly-traded market for the first time.
One common example of a new issue is an initial public offering (IPO), which happens when a company sells shares on the stock market for the first time. When this happens, a company may sell bonds or stocks to raise growth capital.
What Are Over-The-Counter (OTC) Bonds?
Bonds are often traded between investors in the secondary market through brokers. However, they are not sold on stock exchanges. Rather, they are sold OTC between investors.
OTC markets have less transparency and are less regulated than exchange-traded securities. They are also less liquid. As a result, they come with greater risk.
Do You Have to Pay Federal Taxes on Muni Bonds?
Bonds issued by state governments, local governments, or city governments are generally spared from federal taxes. Additionally, you may not have to pay state taxes on muni bonds. However, you will have to pay local taxes on muni bonds. As with the case of any investment, check with your tax advisor so that you don’t get hit with any unexpected tax bills.
What Are Junk Bonds?
Junk bonds are bonds that have a higher risk of defaulting. These bonds typically have higher interest rates but worse credit ratings. Invest in junk bonds at your own risk. Does it really make sense to pour money into something with the word “junk” in it, anyway?
Are Bonds Better Than Mutual Funds?
It depends on what you are looking for. If you’re looking for more security, bonds are the better bet because companies are required by law to pay back bondholders first when they go bankrupt. If you’re looking for growth, mutual funds are generally the way to go because fund managers are focused on optimizing returns.
Most investors choose to leverage bonds alongside mutual funds as part of a diversified portfolio.
How Does SIPC Protect Bondholders?
The Securities Investor Protection Corporation (SIPC) is a nonprofit, nongovernment membership corporation founded by member broker-dealers. All brokerage firms that issue bonds or stocks to consumers are required to be SIPC members.
SIPC offers limited coverage to investors if a brokerage firm becomes insolvent. In addition, SIPC may protect consumers from unauthorized security trading.
The Bottom Line
Buying bonds is an excellent way to diversify and grow your investment holdings. Bonds are an attractive choice for short- and long-term investing—in both brokerage accounts and retirement accounts.
As an added bonus, purchasing bonds is also a great way to support the federal government or local municipality in a time of need. For example, war bonds—or Defense Bonds—were last issued in World War II to remove money from circulation and reduce inflation. You may also choose to buy local bonds to support your city or town—or from a company that you want to support.
The trick is to assess the overall level of risk with a bond and compare it to the expected return on investment. Only you can determine your risk tolerance.
Above all else, do your research before jumping in. Bonds are considered to be secure investments, but you have to know what you’re getting involved with.
Here’s to building a well-balanced and fruitful portfolio that meets your financial goals!