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Updated on Thursday, January 23, 2020
When it comes to investment news, stocks tend to dominate the headlines. Yet, bonds are just as important for investors looking to create a diversified investment portfolio. Since bonds aren’t covered as much in the news, and can be harder to understand, they can be intimidating to invest in for the first time. This guide aims to explain what you need to know about bonds as a personal investor.
What are bonds?
Government entities, public corporations and private companies issue bonds to raise money. A bond works like a loan: When an investor buys a bond, they agree to give a set amount of money to the bond issuer for a fixed amount of time. During this time period, the bond issuer pays the investor a set rate of interest, either at regular intervals or in a single installment. At the end of the bond term, the organization pays the investor back the original sum of money they lent out.
For example, you buy a $1,000 10-year bond from Google with a 5% interest rate. Every year, you will receive $50 in interest ($1,000 x 5%). At the end of 10 years, Google will give you the $1,000 back.
What’s the difference between bonds and stocks?
Companies can raise money by issuing both stocks and bonds. When you buy stock, you become a part owner of the company and get to share in their profits. When you buy a bond, you are a lender. The company agrees to pay you interest in good times and bad — it’s not based on their profits.
Stocks are riskier because your return is not guaranteed. If the company doesn’t earn a profit, you won’t receive money and your investment could lose money. With bonds, you receive the interest payments each year, plus your money back at the end of the term (unless the company runs into financial trouble). However, stocks historically have a higher long-run return than bonds. It’s a tradeoff between risk and return.
What are bond credit ratings?
Besides the interest rate, another key factor for bonds is their credit ratings. While the bond issuer promises to pay interest and your money back at the end of the term, if they run into financial trouble, they might not be able to make all the interest payments. Even worse if they go bankrupt, you might lose part or even all of your initial deposit.
That’s why as part of your research, you should check the credit rating of any organization issuing a bond. Independent agencies — Standard & Poor’s, Moody’s and Fitch are the most prominent ones— review the finances of different organizations and give them a letter score based on what they see.
If a government or company is in strong shape financially and very likely to pay the money back, they will have a high rating like AAA. Riskier bonds will have a lower rating to show they are more likely to miss payments. Bonds with a rating below BBB- on the Standard & Poor’s system lower are called junk bonds because of their extra financial risk.
Typically, a bond with a worse credit rating pays a higher interest rate — otherwise, investors wouldn’t buy them. On the other hand, safe bonds can get away with paying a lower interest rate.
How do bonds compare against CDs?
There are certain similarities between bonds and certificates of deposit (CDs). They are both I.O.U.s from an issuer, which promises to pay you interest plus your original deposit. Still, there are also some important differences between bonds and CDs.
First and foremost, CDs issued by banks are insured by the Federal Deposit Insurance Corporation (FDIC). If the issuing bank goes out of business, the FDIC will in most circumstances return your money, up to the legal limit per account. Bonds do not have this protection, so if the issuer goes bankrupt, you could lose your money.
Another difference is that you can sell bonds to other investors for a profit or loss after buying them. With bank CDs, you can take your money out early in exchange for paying a penalty fee, but generally you can’t sell the CD to another investor (unless you buy brokered CDs).
According to Steven W. Kaye, CFP and managing director of Wealth Enhancement Group, CDs are much simpler, as they only have two components, “interest rate and the term of the investment,” adding that they are “two dimensional” and “completely predictable as long as you stay within the FDIC limits.” However, he pointed out that bonds typically have better returns.
What are the different types of bonds?
The bond issuer is the main differentiator among the types of bonds: is it a company, the federal government, a state? Some of the more common bond types include:
- Corporate bonds: Corporate bonds come from private companies like Google, Ford or Exxon. Companies in good financial condition will have a higher credit rating, whereas struggling companies will have a low credit rating.
- Treasury bonds: Bonds from the U.S. federal government are called treasuries. They have different names based on their terms: treasury Bills have a term of one year or less, treasury notes last between two and 10 years, and treasury bonds have a term of 30 years. These are some of the safest investments in the world because they are backed by the U.S. government. You can also buy bonds issued by other national governments.
- Savings bonds: Savings bonds are also issued by the federal government, and they pay a set interest rate on your investment. You can buy these bonds for as little as $25, much lower than other categories. Another difference is that you cannot sell a savings bond to another investor. Instead, you can redeem them early with the U.S. Treasury, in exchange for forfeiting some of your interest.
- Municipal bonds: When state and local governments raise money, they sell municipal bonds. These can be safe, but you’ll need to check the rating, as not every state or town is in good financial shape. To help state and local governments raise money, the IRS gives municipal bonds a tax advantage: You do not need to pay federal income tax on the interest from most municipal bonds. They also may be free of state and local taxes, depending on where you live.
- Zero-coupon bonds: While most bonds pay interest, you could also find zero-coupon bonds that do not. Instead, you buy these bonds at a lower price initially and then get more money back at the end. For example, you pay $800 and get $1,000 back in five years. That larger lump sum payment at the end can be nice, but the downside is these bonds don’t pay out interest income each year.
How do you buy bonds?
One way to buy bonds is directly from an organization when they release them for the first time, known as a primary issue. You can also buy and sell bonds on the secondary market from other investors. For example, you buy a 3-year old Google bond that still has seven years left of payments from an investor. This can give you more options as companies aren’t issuing new bonds every day.
Finally, there are bond mutual funds and exchange traded funds (ETFs). These are professionally managed funds that build a portfolio of many different bonds for a large group of investors. By buying into the fund, you get a small piece of the entire portfolio.
Kristi Sullivan, a CFP from Denver, thinks that funds are the best option for beginner investors because they help you get more exposure with a smaller investment.
“There are different areas of the bond market (investment grade, high yield, foreign, and various maturities) and many bond funds specialize in these sub-asset classes,” said Sullivan. “You can also buy individual bonds, but they sell for about $1,000 per bond so it takes more money to create a diversified bond portfolio that way.”
What sets the price of bonds?
When organizations issue bonds, they typically set the price for each one at $1,000. However, after the initial issue you can buy and sell bonds on the open market and the price can change.
One major factor is market interest rates. When interest rates go up, the prices of old bonds go down. If you have an old bond paying 4% but now people can go out and buy a brand-new one for 5%, you need to give them a price discount for them to accept the lower interest payments. This is called selling at a discount.
On the other hand, if interest rates go down, the price of old bonds go up. You could sell your original $1,000 bond for more than that, like $1,100. This is called selling your bond at a premium. To get an approximate value of how much your bond is worth based on its interest rate versus market rates, you can use an online calculator like this one.
Investors buy and sell bonds to each other through financial markets so the actual price you’ll receive depends on what someone else is willing to pay for your bond.
Another factor is the underlying finances of the bond issuer. If the bond issuer runs into financial trouble after you sign up, investors are going to be reluctant to buy that old bond so the price will fall to make up for the extra risk.
Are bonds a safe investment?
Bonds are a moderately safe investment, especially compared to stocks. While there is a chance you might not get your money when an issuer runs into financial trouble, if you buy higher-grade bonds you are relatively secure against facing losses. In other words, you should receive the interest plus your money back. However, as Kaye pointed out, there are other types of risk as well.
“CDs and high-quality bonds are safe in terms of default risk but have inflation risk,” he said. Recently for these kinds of investments, “rates have been so low that after you subtract income taxes and inflation, you could actually have a negative return.” Stocks, on the other hand, with their higher potential return, “provide inflation protection.” This is why a diversified portfolio has a mix of different assets, so you get all their advantages.
What are strategies for investing in bonds?
We asked financial advisors whether they had any tips for investing in bonds; here are a few they thought worth considering.
- Stick with high-quality bonds. Kaye believes that beginners should stick with high-quality bonds, those with a high credit rating. That way you can feel confident that your interest income will come in each year and that you won’t lose your initial investment. While the higher interest rates on junk bonds may be tempting, they are more likely to lose money.
- Avoid micromanaging: With so much research and daily news out there, beginner investors can overreact to market changes. “I am a buy-hold-annual-rebalance advisor, so I’d say don’t micromanage your bond investments,” said Sullivan. So after buying a bond, wait a year before making any buy/sell decisions.
- Consider bond funds for lower budgets: “For those who do not have enough money to buy individual bonds, there are investments like BulletShares, which is a basket of bonds with specific maturity dates for smaller investors,” suggests Kaye.
- Keep in mind tax breaks from municipal bonds. Marguerita Cheng, CFP and CEO of Blue Ocean Global Wealth, sometimes sees people misusing the tax breaks on municipal bonds. “It doesn’t make sense to have municipal or tax-free bonds in tax-deferred accounts, such as IRAs. The benefit to investing in municipal bonds is that they are exempt from federal & state taxes.” Since municipal bonds are already tax-free, you should keep them in a regular brokerage account while saving your retirement plan tax breaks for taxable bonds.She also says you should watch out for your state’s rules for bond taxes. “In states like Virginia, Virginia residents can purchase Virginia municipal bonds and not be subject to state or local income tax. While they can purchase bonds from another state, those would not be exempt from Virginia taxes.”
- Consider a bond ladder. One risk with bond investments is that interest rates will change after you sign up. To get around this, you could set up a bond ladder, where you buy bonds with different maturities. For example, rather than putting all your money in 5-year bonds, you divide it up between 1-year, 3-year and 5-year bonds.If interest rates go up after you buy, you’ll be able to renew the 1-year bonds soon at a better rate. If interest rates go down after you sign up, you’ll still keep the higher rates on your longer-term bonds. By getting a mix of short and long-term bonds, you cover yourself in both scenarios.
How can someone get help investing in bonds?
If you still need some help figuring out how to trade bonds, there are ways you can prepare. First, you can see whether the broker selling the bonds can give you advice. FINRA, an investment regulatory agency, recommends that you look for a broker that specializes in bond trading so you can get this support.
Another option is to buy bond funds and ETFs. The fund prospectus will list the types of investments and fees so you can find one that’s appropriate for your situation. For more hands-on support, you could hire a financial advisor, who could recommend a suitable bond portfolio for your goals and even personally manage it for you. You would need to pay for this advice, either as an hourly fee or as a percentage of your portfolio every year.
Whichever system you use, you will be adding a valuable asset class to your portfolio that balances out your stocks. With a little research and the information in this guide, you can feel more confident about your bond investing decisions.