Bond Investing for Beginners: What You Need to Know
Investment discussions are typically focused on the stock market, but any financial adviser will tell you that a diversified portfolio is the most effective type of portfolio.
That means you shouldn’t limit your investments to just stocks. Bonds are also included in a well-balanced portfolio.
Investment options such as bonds are inherently low-risk. However, they do not have the high potential earnings of stock investments. Rather, purchasing bonds acts as a hedge against the riskier stocks in the market.
Understanding when and how to invest in bonds is an important part of developing a successful investment strategy for yourself.
What Is a Bond?
You take out a loan to pay for something you don’t have the full amount of money for. They issue bonds when they need to borrow money for a specific purpose.
They promise to return the money to the bondholders (that’s you!) at the bond’s maturity date, or the end of the bond.
Bonds can be issued for a variety of purposes, from raising funds to fund product development to raising funds for the construction of new infrastructure.
Along the way, the bond issuer also pays interest, which is typically done twice a year by the issuer. Coupon payments are what they’re called.
Zero-coupon bonds, which don’t pay interest until the maturity date, are the only exception to this rule. Some parents use them as a way to save for their children’s college education, with the hope that the bonds will mature when the time comes.
3 Types of Bonds Explained
As a beginning investor in the bond market, you should be familiar with the following three types of bonds: Treasury bonds, municipal bonds, and corporate bonds. Treasury bonds are the most common type of bond issued by the government.
Treasury bonds, also known as T-bonds, are issued by the United States government. There is no risk of default because they are fully backed by the federal government and have maturities ranging from 10 to 30 years. The interest you earn is tax-free at the state and local levels, but you’ll still have to pay federal taxes on it if you live outside of the United States.
What is the most significant advantage of a Treasury bond? Unless the United States government goes bankrupt, it is virtually risk-free. And if that happens, we’ll most likely have more serious problems to deal with.
Treasury bonds typically have interest rates that are similar to those of comparable municipal bonds.
Municipal bonds, or “munis,” are issued by cities, states, and other local governments to fund infrastructure projects like road construction and park renovation.
In the United States, interest on municipal bonds is exempt from federal income taxation. The municipal bond purchased in your home state is frequently exempt from both state and local taxes, as is the interest earned on the bond.
An additional benefit: as a citizen, you reap the benefits of your investment by taking advantage of the services provided by your city and state on a daily basis.
Municipal bonds are divided into two categories:
- General obligation bonds, which are used to fund public works. These bonds are backed by the full faith, credit and taxing power of the issuer. That means that, if necessary, the issuer will raise taxes to repay bondholders.
- Revenue bonds are backed by a specific project, like a hospital, toll road or stadium. They aren’t backed by the full faith and credit of the issuer, which makes them riskier. They pay higher interest rates than general obligation bonds because of the higher risk.
Corporate bonds are the most risky of the three types of bonds available to investors.
This type of bond is different from the previous two types of bonds in that it is issued by a company. Purchasing a corporate bond from a company is distinct from purchasing stock in that company, which grants you partial ownership in that company, whereas with a corporate bond, you are lending the company money.
They come with a credit risk, which means that if the corporation is unable to make its debt payments, bondholders may not receive their interest and principal payments, as well as their principal payments.
Upon the filing of a bankruptcy petition by the corporation, secured creditors are paid in full before bondholders receive a return on their bond investments.
In general, the most attractive feature of a corporate bond is that it will typically pay the highest interest rate of the three main types of bonds available.
4 Benefits of Investing in Bonds
Investing in bonds has several key benefits:
1. They Are Generally Safe Investments
Risk is inherent in all investments to some degree. With Treasury bonds, there is virtually no risk of default. However, because the risk is low, the interest payments on the bonds are also low.
By doing so, you run the risk of them failing to keep up with inflation. In addition, you may miss out on other investment opportunities that offer higher returns on your money. However, if you have a low to non-existent risk tolerance, these bonds may be right up your alley.
Defaulting on a municipal or investment-grade corporate bond is extremely rare, but if it does happen, you’ll lose your money.
Default is more likely with junk bonds, which are the riskiest bonds issued by corporations. To compensate investors for the increased risk, they offer a high dividend.
Because the stock market can be so volatile, fixed-income investments like bonds can offset the high risk of stocks.
As investors near retirement age, they can no longer afford to take on as much risk. Financial advisors advise investors to gradually increase their bond holdings as they get older.
2. They Provide Fixed Income
In terms of the income stream, bonds provide some predictability because the coupon payments are usually made twice a year, on a quarterly basis.
Bonds are a popular investment choice for retirees because they provide a guaranteed stream of income. In fact, the term “bond” can also refer to a fixed-income security.
This is a stark difference from stocks, which are much more volatile and thus cannot be relied on for fixed income.
3. They Give You the Chance to Give Back
Municipal bonds, in particular, are appealing because they give you the sense that you are contributing to the betterment of your own community. A similar statement can be made about Treasury bonds, albeit on a larger scale.
Even corporate bonds, if you are passionate about a specific product or brand for which the company is raising money, can instill a sense of investing purpose in you.
4. They’re Easy to Manage
If you don’t work with a financial advisor, it can be difficult to make money in the stock market. When are you planning to purchase it? When do you plan to sell? And how do you go about doing those things?
It is possible to earn income from bonds simply by purchasing them once and holding them until they mature, although some investors sell their bonds before they mature, whether at a profit or loss.
3 Drawbacks to Investing in Bonds
Bonds are not without drawbacks. Here are a few:
1. Most Bonds Aren’t High Earners for Your Portfolio
Bonds provide stability in a diversified portfolio, can be a reliable source of income, and can be used to counterbalance the risks associated with high-risk stocks. Bonds can be used to counterbalance the risks associated with high-risk stocks. However, the reward is proportional to the level of risk that is taken. [page number] When compared to the growth of the stock market, bond growth is negligible.
According to a CNN Money report, large-cap stocks have generated an average annual return of 10% since 1926, while large-cap government bonds have generated an average annual return of 5–6% over the same time period.
2. There Is Still Risk Involved
The Federal Deposit Insurance Corp. insures deposits up to $250,000, so you have nothing to worry about when you keep your money in a certificate of deposit, money market account, or savings account at your financial institution.
Investing in bonds, on the other hand, comes with a degree of risk, but it is far less than that of investing in stocks. It is possible that the bond issuer will default on the bonds, resulting in a loss of interest or even the loss of your entire investment. Credit risk is a term for this.
Interest rate risk is another type of bond risk. Bond prices fall as interest rates rise, reducing the value of your bonds. This is because investors can earn more money elsewhere by earning interest.
Bond prices rise when rates fall, so your bonds may be easier to sell if they’re paying higher interest rates than the market rate at the time of purchase.
Another liability to take into account is the risk of inflation. A bond’s interest payment can’t keep up with inflation, so you end up with less purchasing power than you had when you bought it.
Liquidity risk is the final consideration. You can’t access your money if you have it invested in a specific asset class, such as stocks or bonds.
In order to meet a financial obligation, you may have to sell your bonds at a lower price and lose money if you cannot find a buyer.
3. Your Funds Are Tied up
Typically, buying bonds necessitates a long-term investment mindset.
Your money can be accessed whenever you need it, and stocks can be purchased as needed. You must wait for bonds to mature before reaping the full benefits of your investment.
How to Invest in Bonds
Unlike stocks, which are traded on a public exchange, bonds must be purchased from brokers — unless you are interested in government bonds, which you buy from the United States directly.
How Are Bonds Rated?
Investors use bond ratings to determine the strength of a bond and the likelihood that the issuer will repay the principal and interest on time. What is the source of these ratings? Ratings agencies are organizations that provide opinions on products and services.
A bond’s strength can be evaluated using bond ratings from Moody’s, Fitch, and Standard & Poor’s. Bonds’ credit quality, maturity, and yield should be your primary concerns.
Confusion may ensue if you don’t understand how the scoring works. High-grade bonds with AAA to AAAA ratings are considered safe investments with a good chance of being repaid (though the interest rate is likely to be much lower). Investment-grade bonds with ratings of BBB to Baa are also safe bets because of their low default risk.
When investing in BB and Ba bonds, also known as junk bonds, you are assuming more risk because of the greater price volatility associated with these bonds. The more risk you take, the greater the potential reward.
A bond rated as D is currently in default. Stay far away.
Individual Bonds vs. Bond Funds
The amount of money you can put into bonds is determined by a variety of factors. The Treasury sells its individual bonds in $1,000 increments, for example.
Individual bonds issued by municipalities and corporations typically have a $10,000 minimum purchase price and can go as high as $100,000.
There are two types of bond funds: mutual funds and ETFs (Exchange Traded Funds).
Investing in a bond mutual fund or ETF is like investing in a variety of different investments in one place. If one of the bonds in that bond fund defaults, you still have the other bonds to safeguard your investment.
Many financial advisors use mutual funds, which are made up of both stocks and bonds, to protect their clients from big risks.
Bond mutual funds must be purchased through a mutual fund company, but bond exchange-traded funds can be bought and sold on the stock market.
The issuers of individual bonds should be thoroughly vetted before you put your money into them.
Bonds are an important part of a long-term investment strategy, but they aren’t the only part. An investment advisor can help you determine the best mix of stocks and bonds for your overall portfolio.
How to Open a Brokerage Account
The only way to buy bonds without a brokerage account is to invest in government bonds.
Open and manage your own brokerage account without the help of a third party by using a financial advisor (who can provide useful investment advice) or a robot advisor.