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Learn How Futures Trading Works

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Futures are a kind of contract that guarantees the delivery of a certain amount of a product or commodity at a certain time in the future at a certain price. These products include tangible goods, such as corn, gold, oil and pork bellies, as well as intangible products, such as currency and stock indexes.

Here’s how futures trading works and what you need to know before diving in.

What is futures trading?

Futures trading is an agreement between a buyer and seller to exchange a good in the future for a preset amount of money. The buyer agrees to pay the cash at the future date, and the seller promises to deliver the product at that time. This point is important — with a futures contract, the buyer is agreeing to take delivery of the commodity, and sometimes taking delivery of that product (such as oil, cattle or sugar) requires a lot of physical infrastructure.

Futures trading usually is the province of highly sophisticated participants, often those who use the commodity or product being traded. But it also includes traders who simply speculate on the price movement of the futures.

Key players

The key players in the futures markets include:

  • Commodity producers and users: These players are buying or selling futures to hedge their bets on a commodity’s price. They use or produce the commodity and want to guarantee a sale at a set price of part or all of the commodity. In this way, they reduce their risk and lock in a price in an often-volatile market. They either deliver the quantity of the commodity or take delivery of it.
  • Speculators: These players are purely bettors, placing their chips on how they think a commodity is going to move. They’ll never take delivery of a physical commodity and will close their position before the delivery date.
  • Other hedgers: These players may own an investment that is exposed to a commodity, so they buy or sell futures to hedge or protect their other investment.

These three groups consist of companies in the given commodities industry, individual and professional traders, and institutional investors, such as pension funds, hedge funds and others.

Top futures exchanges

These traders are exchanging standardized contracts that are swapped on a futures exchange. In the U.S., many of the top futures exchanges are run by CME Group, including the following:

  • Chicago Mercantile Exchange (CME): offers contracts on many agricultural products as well as those on financial products
  • Chicago Board of Trade (CBOT): noted for its exposure to agricultural commodities
  • New York Mercantile Exchange (NYMEX): specializes in energy futures
  • Commodity Exchange (COMEX): noted for its metals futures

Commodities trading is regulated by the U.S. Commodity Futures Trading Commission (CFTC). The CFTC oversees not only commodities futures (such as for corn and soybeans) but also futures for financial products (such as for currency and stock indexes).

Futures contracts explained

Because they’re standardized, futures contracts specify everything a trader should know about the contract.

They’ll specify the following things:

  • The amount in each contract and the unit (bushel, barrel, ounce, etc.)
  • The currency unit the price is quoted in
  • The delivery date
  • How the trade will be settled — either physical delivery or cash settlement

Futures contracts were created to minimize the risk of price fluctuations in a commodity, so companies that need and produce the commodity can access the market and lock in a future price today. Let’s run through an example to get a sense of how a futures contract plays out.

Imagine a cereal manufacturer needs to ensure a supply of corn at a reasonable price over the winter, avoiding a potential shortage and a subsequent price spike. This producer buys 200 contracts to take delivery of 1 million bushels of corn in December of the following year, 15 months out.

On the other side of the contract is a corn producer — an agricultural giant that wants to be sure it gets a fair price for 2 million bushels of its corn next December to avoid an oversupply and unexpectedly lower prices due to a good harvest. It sells contracts on 1 million bushels to the cereal maker and the remaining contracts to various other buyers.

In this example, both parties can benefit by trading some risk, with each locking in future prices at a price that looks good today. Of course, a speculator may jump into the market, expecting the price of corn to rise, and buy corn futures too, maybe buying some from this corn producer. This speculator may sell them later to the cereal maker if it wants to secure more corn.

Regardless of who buys and sells the futures contracts, both buyer and seller must put up a portion of the contract’s value called margin, typically 3% to 12%. This margin is held by the futures clearinghouse as a security on the contract. As the value of the contract fluctuates over time, the parties to the contract may have to add money to the margin to maintain the contract.

After each trading day, the clearinghouse settles the daily accounts between the buyer and seller. If the contract increased in value, it transfers the increase in cash from the seller’s margin account to the buyer’s, and vice versa if the stock fell. If either the buyer or seller falls below the minimum margin level required by the clearinghouse, they’ll have to deposit more money.

Finally, when the delivery date arrives, that’s when the buyer and seller settle up the contract. The buyer will pay the agreed amount, and the seller will deliver the fixed quantity of goods. It’s important to reiterate that a buyer may be agreeing to take physical delivery of goods for commodities in the future or to settle accounts in cash with financial products.

Types of futures markets

There are two broad kinds of futures markets: commodities futures and financial futures. Here are some major products that are exchanged in each.

  • Commodities futures: These commodities consist of the following categories:
    • Metals (including gold, silver, platinum)
    • Agriculture (including corn, soybeans, coffee, cotton, sugar, wheat)
    • Energy (including oil, gasoline, jet fuel, natural gas)
    • Livestock (including hogs, pork bellies, cattle)
  • Financial futures: These products consist of the following categories:
    • Foreign exchanges (including contracts that de-risk currency fluctuations)
    • Indexes (including contracts covering the S&P 500)
    • Interest rates (including swaps of interest payments)
    • U.S. Treasury futures (including contracts on U.S. debt)

There are many other kinds of commodities and financials traded on the exchanges.

How to trade futures

It can be relatively easy to get started trading futures, though it pays to quickly educate yourself before wading in too deep. Many discount brokers offer futures trading — including the larger full-service brokers — but more specialized futures brokers also are available.

In addition to the usual personal information, the broker will ask you questions about your income and assets to gauge how much risk you will be allowed to assume.

While a broker may have a low account minimum to open an account or none at all, that doesn’t mean that you’ll be able to trade immediately if you deposit the minimum. Each futures contract has its own minimum initial margin, depending on the broker. Often that minimum is a few thousand dollars, so you’ll need at least that amount to get in the game. And then if the contract moves too much against you, you’ll have to deposit more cash to maintain it.

For example, if you’re in the market for an E-mini futures contract on the S&P 500, you’ll need at least $6,600 at one broker to open a contract. Once you have an open position, the broker gives you a bit of wiggle room to hold the contract. As long as your account has at least $6,000 in value (the contract plus any cash), you’re in good standing. When it dips below that amount, the broker will call on you to immediately deposit cash to make up the deficit or sell the contract.

If you’re unable to obtain the ability to trade futures directly, it’s possible to buy exchange-traded funds (ETFs) that give you exposure to commodities futures. These ETFs often are categorized by commodity type (gold, oil, etc.), and some even offer leveraged exposure to the price of the commodity. Plus, you can make a bet on either the upward or downward move of the commodity. There are at least 100 commodity ETFs trading in the market. A sugar ETF? Yes, there is.

What are the risks of futures trading?

There are two major risks in trading futures, especially commodities futures: price volatility and leverage. Traders like the leverage and price volatility of commodities because they have a chance to profit very quickly, but there is a risk of losing a lot of money just as quickly. Savvy traders avoid exposing themselves to too much risk in any one position.

Here’s what you should know about each one.

Price volatility

Commodity prices can fluctuate a great deal, often in response to unexpected factors, such as catastrophic weather or natural disasters (hurricanes, earthquakes) or more mundane events (an extra long winter or a rainy summer). And commodities may fluctuate for no reason at all or merely because some speculators run the price up or down.

Leverage

Using a margin account, commodities exchanges allow traders to put up only a portion of the contract’s value in order to own it, giving the trader leverage. In other words, this practice allows traders to own more contracts than they have the money for currently. So this leverage allows a small amount of money to control a much larger amount of money.

As long as the trade moves in the trader’s direction (increasing in value), the trader won’t have to deposit more money into the margin account. However, if the contract decreases in value enough, the trader must put more money into the account or otherwise sell the contracts. It’s possible that a volatile price swing (see point No. 1) could lose more than the trader initially invested. If you can’t meet the margin call on a timely basis, the brokerage will sell enough to do it for you.

Is futures trading right for you?

Trading is tough, and it’s even tougher in commodities markets than in (slightly) more predictable arenas, such as the stock and bond markets. The price of commodities can fluctuate violently sometimes, and the leveraged nature of futures contracts can force a futures trader to put up substantial cash just when it’s in short supply.

Individuals often don’t have enough information to compete with well-informed institutional and professional traders. These pros know their specific markets thoroughly and have information flow that may never be reported in traditional news outlets. If a big institution decides to move, it can shift the whole market, and small individual players are forced along with it.

Traders in any market — but perhaps especially in the futures markets — need to have strong risk management. They should understand when to close a position, especially a losing position, so they don’t risk a catastrophic loss. Psychologically, that’s one of the toughest things to do, but it’s the most important because it limits the damage to your bankroll from any one trade.

Bottom line

Futures trading can be tough for a new trader, and it requires a higher level of sophistication and trading acumen than stock investing. But it’s popular because the leveraged nature of futures contracts makes possible a rapid gain on a small change in the commodity’s price. Of course, it’s just as easy to lose money on a small downtick in price too.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

James F. Royal, Ph.D.
James F. Royal, Ph.D. |

James F. Royal, Ph.D. is a writer at MagnifyMoney. You can email James here

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Review of LPL Financial

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

LPL Financial is the largest independent broker-dealer in the United States based on gross revenue. Dually registered as an investment advisor, the firm supports a network of over 16,000 affiliated advisors who operate their own businesses. LPL Financial is based in Boston, and it also has offices in San Diego and Fort Mill, S.C. The network of advisors it supports are located throughout the country. The firm’s advisors oversee nearly $159.1 billion in assets under management (AUM).

All information included in this profile is accurate as of January 23rd, 2020. For more information, please consult LPL Financial’s website.

Assets under management: $159,099,423,965
Minimum investment: Varies by service and portfolio type
Fee structure: Percentage of AUM, hourly fees, fixed fees and commissions
Headquarters:75 State Street
22nd Floor
Boston, MA 02109
617-423-3644
www.lpl.com

Overview of LPL Financial

LPL Financial was founded in 1989 after the merger of two smaller brokerage firms, Linsco and Private Ledger. With 16,109 advisors and 17,205 licensed insurance agents on its staff, LPL has $159.1 billion in assets under management LPL Financial is owned by LPL Financial Holdings, a publicly traded firm.

Advisors often choose to affiliate with LPL to tap into the firm’s technology, investment research and business building support, for which the firm earns a fee. LPL advisors maintain their own relationships with clients and negotiate their own fees and service offerings independently. LPL does not sell any of its own proprietary financial products, so advisors are free to recommend whichever investments and financial products they believe are in their clients’ best interests.

What types of clients does LPL Financial serve?

LPL Financial’s advisors serve mostly individual investors. In addition, the firm serves:

  • High net worth individuals
  • Trusts and estates
  • 401(k) plans
  • Individual retirement accounts
  • Pensions and profit-sharing plans
  • Charitable organizations
  • State and municipal entities
  • Corporations

The minimum amount of assets required to work with an LPL advisor varies depending on the service you receive. LPL does not have a minimum asset requirement for its financial planning, consulting or research services. For customized investment advisory plans, the investment minimum is up to the discretion of the advisor and is detailed in the client agreement.

Clients who opt to use one of the firm’s portfolio programs will be subject to minimum requirements that vary by program. Minimums start as low as $5,000 for Guided Wealth Portfolios and go up to $250,000 for Personal Wealth Portfolios (see more details on these options below).

Services offered by LPL Financial

LPL’s financial advisors offer the full gamut of financial planning and advisory services, such as budgeting, financial projections and selling insurance, though not all advisors offer every type of service. Among the services LPL advisors may offer are:

  • Investment advisory services and portfolio management
  • Wrap programs
  • Financial planning
  • Insurance
  • Retirement plan and pension consulting
  • Selection of other advisors
  • Workshops and seminars
  • Brokerage services

In addition to the services that LPL advisors provide directly to clients, when advisors affiliate with LPL, they get access to a range of services to help them build and manage their businesses. This includes business building ideas, compliance and technology support, investment research and the execution of trades.

How LPL Financial invests your money

Because LPL’s advisors work independently, investment approaches and strategies vary from advisor to advisor and client to client. Advisors can offer customized investment advisory services, and LPL also provides advisors with programs for investing client funds.

One option offered by LPL is the Strategic Asset Management program, which allows a high level of customization so clients can choose to exclude certain investments or emphasize others. The program offers access to a full range of investment options, including mutual funds, exchange-traded funds, equities, fixed income and alternative investments, such as non-traded real estate investment trusts and non-traditional exchange-traded funds.

Advisors who want to take a more hands-on approach with their high net worth clients can use a separately managed account wrap program from LPL called Manager Select. With this program, LPL reviews and recommends outside institutional portfolio management firms for inclusion.

For advisors who don’t want to create customized portfolios, there is also the option to invest clients’ money in one of LPL’s model portfolios. These portfolios — which include Personal Wealth Portfolios, Model Wealth Portfolios, Optimum Market Portfolios and Guided Wealth Portfolios — are professional asset allocation strategies that are created, managed and monitored by LPL. Mutual funds and ETFs make up the investments within these portfolios, but the exact mix will depend on a client’s responses to an online questionnaire about their financial goals, investment horizon and risk tolerance.

Portfolio NameInvestment Strategy
Strategic Asset Management
($25,000 minimum)
Open architecture program that allows advisors to invest client assets in mutual funds, ETFs, individual equities, variable annuities and other investments.
Manager Select
($50,000 minimum)
Separately managed wrap program for high net worth clients that uses LPL-researched and monitored institutional portfolio managers.
Personal Wealth Portfolios
($250,000 minimum)
Asset allocation investment program that combines mutual funds, ETFs and investment models for high net worth investors.
Model Wealth Portfolios
($10,000 minimum)
Program that uses strategic asset allocations to take advantage of market opportunities that will persist for the next 3 or 5 years; designed for more aggressive investors.
Optimum Market Portfolios
($10,000 minimum)
Suite of model portfolios that invests in up to six mutual funds from the Optimum Funds family.
Guided Wealth Portfolios
($5,000 minimum)
Digital investment platform for low-balance investors.

Fees LPL Financial charges for its services

It’s up to LPL advisors to determine how to charge for their services. Advisors use several fee models, including a percentage of assets under management, hourly fees, fixed fees and commissions. Fees are negotiated between clients and their advisors and detailed in the client agreement. All fees are paid directly to LPL, and LPL then shares a portion with the independent advisor representative.

That said, the firm typically charges for financial planning consulting services on an hourly or per plan basis, which is a flat rate. The maximum hourly fee that LPL advisors will charge is typically $400 per hour, while the maximum flat fee is typically $15,000.

For customized advisory services, LPL typically charges based on a percentage of assets under management. A client’s rate will be set out in their agreement with the firm. LPL states in its Form ADV that the maximum rate it generally charges is 1.50%.

For clients who opt to participate in one of the programs offered by LPL that’s laid out above, they will also pay a fee based on a percentage of assets under management. The maximum account fee is generally 2.50%.

Along with the account fees, clients may pay other miscellaneous administrative or custodial-related fees and charges. Clients are notified of these fees when they open an account, and LPL provides clients with a list of fees on its website.

LPL Financial’s highlights

  • Awards and recognition: LPL advisors consistently appear on top advisor lists. In 2019, for example, 65 LPL advisors ranked among the best advisors in their states in Forbes’ list of Best-in-State Wealth Advisors. Deborah Danielson, an advisor based in Las Vegas, ranked No. 3 in her home state on Barron’s list of 1,200 Top Financial Advisors in 2019.
  • Advisors for all types of clients: Because LPL has a vast network of advisors across the U.S., clients are likely to find an advisor whose specialty matches their needs. In addition to one-on-one advice with advisors, clients can also tap into technology-assisted portfolio management platforms similar to what they might find at a robo-advisor.
  • Inclusive workplace: Human Rights Campaign gave LPL a 100% score in its Corporate Equality Index as one of the “Best Places to Work for LGBT Equality.”

LPL Financial’s downsides

  • Advisor defections: Over the last few years, several big RIA firms have left LPL, citing the firm’s lack of service to their advisor groups. These groups included Retirement Benefits Group, which managed $10 billion, and Resources Investment Advisors, which oversaw $5 billion.
  • Potential conflicts of interest: Some LPL advisors are dually registered, meaning that they are able to charge fees for financial advice as well as for products they recommend, such as 12b-1 fees, paid to cover distribution costs for mutual funds. This could incentivize advisors to sell certain products. One way that LPL has attempted to mitigate these potential conflicts is to credit back certain fees to client accounts, thus eliminating the financial incentive.
  • Numerous disclosures: Over the years, LPL has been fined on several occasions for failing to supervise its brokers carefully, leading to sales of inappropriate and complex investment products.

LPL Financial disciplinary disclosures

LPL has had a long history of disciplinary disclosures, many of which are centered around the firm’s failure to properly supervise its brokerage practices. The firm has been ordered to pay fines and restitution as a result.

Among the most serious instances of wrongdoing, LPL was fined $26 million in 2018 for failing to establish and maintain reasonable policies and procedures to prevent the sale of unregistered, non-exempt securities to its customers.

In 2015, the firm was fined $11.7 million for “broad supervisory failures” in a few key areas, such as non-traditional ETFs, variable annuities, non-traded real estate investment trusts and other complex investment products. The firm was ordered to pay an additional nearly $1.7 million in restitution directly to clients who had bought non-traditional ETFs.

LPL Financial’s onboarding process

Advisors have their own onboarding process when they sign on new clients. LPL has recently streamlined its sign up process by reducing the number of fields clients must fill in and introducing a progress bar.

If you are interested in working with an LPL advisor, you can find one near you by searching on the firm’s website. You can either search for a specific advisor by name or take a look at the advisors in your area.

Is LPL Financial right for you?

With LPL’s vast network of affiliated advisors, potential clients should be able to find an advisor who can address their needs. However, LPL’s size does bring downsides — indeed, the firm has faced numerous disciplinary actions in recent years. Further, some of LPL’s advisors are dually registered as brokers and receive commissions for sales, which could create potential conflicts of interest. Some investors may prefer a smaller, more intimate advisory practice with fewer potential conflicts of interest and a more personalized feel.

Before choosing a financial advisor, it’s always important to do your research and compare several options to ensure your advisor is the right fit for you.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Ilana Polyak
Ilana Polyak |

Ilana Polyak is a writer at MagnifyMoney. You can email Ilana here

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Investing

Everything You Need to Know About Bonds

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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 through an investment brokerage account like Fidelity or E-Trade. If you have a retirement account like a 401(k), you could also use money in that account to 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.

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David Rodeck
David Rodeck |

David Rodeck is a writer at MagnifyMoney. You can email David here