Financial experts generally suggest a well-diversified investment portfolio consists of at least two asset classes: stocks and bonds. That’s why bonds, also known as fixed-income securities, can be an essential part of an overall investment strategy.
Whether you’re just starting out or are already well versed in how to invest money, the addition of a bond component can help add security and stability to a long-term investment journey. Ready to get started? Here’s what you’ll need to know about how to buy bonds — and why you might want to.
What is a bond?
A bond is a loan between an individual investor and a company or government entity. When you buy a bond, you’re actually lending a specific amount of money to a bond issuer. In exchange, that issuer promises a specific return on the bondholder’s investment — or a fixed income stream — for a predetermined period of time.
This fixed income stream comes in the form of a regular interest payment, known as a coupon payment, which is often paid twice per year. At the end of the term, 10 years for example, your original investment is also returned to you.
Types of bonds
There are many different bond varieties, which differ primarily based on the type of issuer, that issuer’s creditworthiness, and the term of the bond agreement. All of these different bond types fall within three main categories: corporate, municipal, and treasury securities.
As the name implies, corporate bonds are issued by public or private companies that need access to new sources of cash flow so they can pay for upcoming business ventures. That could include corporate growth, expansion into a new market, the purchase of equipment, or a product launch.
Corporate bonds are generally categorized into two camps:
- Investment-grade bonds are bonds that have been rated favorably by one or more of the three prominent bond-rating agencies within the United States: Standard and Poor’s, Moody’s Investor Service, and Fitch Ratings. The higher the rating, the more confident the agency is that the bond issuer will be able to repay its debt obligation. The highest possible rating is AAA, followed by AA, A, and then BBB. Some agencies also assign plus and minus designations to ratings.
- High-yield bonds, also known as junk bonds or non-investment-grade bonds, have a lower credit rating. This is typically an indication that the issuing company could have trouble repaying its debt obligation. When buying a high-yield bond, an investor accepts a greater level of risk, which is often rewarded with a greater rate of return. Any bond rated below BBB is categorized as junk, but there is variation within the non-investment-grade range. The lower the rating, the higher level of risk.
Also called muni bonds, these debt obligations are issued by states, cities, and counties to pay for various local government-approved projects. That could include the construction of a new school, a revamped highway or sewer system, or the development of a local park or neighborhood library. The interest income from muni bonds is typically exempt from federal and local taxes for residents of the issuing municipality.
Munis generally come in one of three varieties:
- General obligation bonds are unsecured or backed by the full faith and credit of the issuer. In short, the issue is secured solely by the issuer’s promise to repay.
- Revenue bonds are backed by the money earned from a specific project, like highway tolls or building lease fees.
- Conduit bonds are issued by a local government but on behalf of another local organization, like a hospital or nonprofit college.
Treasury securities are issued by the Department of the Treasury and backed by the full faith and credit of the federal government. Because of their federal backing, Treasuries are considered the safest of bond investments.
U.S. Treasury bond types include:
- Treasury Bills, or T-Bills, are short-term issues that mature — or come due for the issuer — somewhere between a few days and 52 weeks from issue.
- Treasury Notes, or T-Notes, are longer-term bonds that come due within 10 years.
- Treasury Bonds, or T-Bonds, are long-term securities that mature somewhere between 10 and 30 years from issue. These issues typically pay interest every six months.
- TIPS, or Treasury Inflation-Protected Securities, come in both note and bond varieties. These offer protection against inflation by adjusting the principal value of the issue as the consumer price index fluctuates. Basically, the value of TIPS rises when inflation rises and falls when inflation falls. At the maturity date of the bond, an investor is repaid either the original or inflated value, whichever is greater. TIPS are offered in five-, 10, and 30-year maturities and generally pay interest every six months.
Why should I buy bonds?
Most financial professionals recommend a diversified investment portfolio that includes a mix of both stocks and bonds. In general, and over time, stocks tend to perform more favorably than bonds, but here’s the thing: Stock prices can rise and fall at rapid rates, which can sometimes make for a bumpy ride.
That’s where bonds come in. Bond prices tends to be more stable, and bond pricing often rises and falls in an inverse relationship with stocks. That’s why adding a few bonds to a stock-heavy portfolio can help smooth a long-term investment journey and help you reach your financial goals.
Risk-averse investors and late-stage careerists tend to prefer a higher proportion of bonds; likewise, younger professionals or those with the mettle to handle the market’s sometimes wild swings may prefer a more stock-heavy portfolio.
An alternative bond-buying strategy is to create what’s known as a bond ladder, by purchasing a number of bonds with sequential coupon dates. These are the dates when interest payments are due to the bond’s purchaser. In essence, the goal is to create a future income stream that is based on the laddered interest payments of the different bonds held within a bond portfolio.
How many bonds an investor chooses to purchase often depends on the frequency of payments desired, as well as the length of time those payments are wanted (once a month for a 30-year retirement, for example).
What are bonds rated and how does that grade affect interest rates?
A bond rating is essentially a grade given to an issue by the rating company so potential investors know how likely the issuer is to make timely interest payments — or even to make them at all. The higher the rating (AAA is the highest rating available), the more stable the issue is presumed to be. Lower ratings (BB and below) indicate higher risk or late or missed coupon (interest) payments.
When it comes to bonds, in general, a lower rating is associated with a higher interest payment. That’s because the issuer usually has to pay more to entice investors to take on the added risk. Think about it like this: A person who has missed a few monthly bill payments will usually be offered a higher interest rate when applying for a loan. The same concept holds true on a corporate level.
What are the risks of investing in bonds?
Although bonds are generally considered a safe investment, there are a few risks investors should be aware of:
- Default risk happens with a bond issuer can’t make the agreed-upon interest or principal payments, either on time or at all.
- Inflation risk occurs when the general price for goods and services rises at a rate that’s higher than the given interest rate for an issued bond. If a bond is issued at a 3% coupon rate, for example, but inflation rises at a rate of 4%, that higher inflation erodes the real value of the bond’s interest payments.
- Reinvestment risk is the risk that the proceeds from a matured bond will need to be reinvested in a bond with a lower coupon rate. If a bond was bought 10 years ago at a coupon rate of 5%, for example, but matures when the prevailing rate is 3%, the investor could lose 2% in future interest income, assuming a plan to reinvest the proceeds.
- Call risk is associated with the concern that an issuer could purchase a bond back and retire the issue if interest rates fall.
- Supply and demand risk is a function of bond trading on the secondary market. In short, many bond owners don’t hold their bonds to maturity. Instead, they sell them over the counter to other investors. As interest rates rise, the cost of bonds trading on the secondary market generally decline, and vice versa. That’s because most investors would expect a discount when purchasing a bond with a 5% coupon rate, for example, when they could instead purchase a newly issued bond at a 6% coupon rate.
How to buy bonds
Primary and secondary markets
The primary market is where securities are born. That includes the initial public offering of stocks and new issues of bonds in the realm of fixed-income securities. Primary markets aren’t very accessible to ordinary investors. The average person usually purchases securities on the secondary market, where already-existing stocks and bonds are traded.
The secondary stock markets include well-known exchanges like the New York Stock Exchange, Nasdaq, and the American Stock Exchange. There are overseas equivalents, too, like the London Stock Exchange and Tokyo Stock Exchange.
Bonds, on the other hand, are typically traded over the counter in the secondary market by large broker-dealers who buy and sell bonds on behalf of clients. Very few everyday investors ever have direct experience with the over-the-counter market.
Individual bonds vs. mutual funds vs. ETFs: What’s the difference?
Although many ordinary investors aren’t likely to buy individual stocks, either through a primary or secondary market, it is quite common to access a bond-specific mutual fund or exchange-traded fund (ETF) through an investment firm, brokerage account, or financial advisor.
A mutual fund is a pooled group of assets that share some features in common. One example is an intermediate-term corporate bond fund, which invests in investment-grade corporate bonds that mature on a five- to 10-year time frame.
Mutual funds come in all shapes and sizes, which makes the investment type a quick, easy way for an investor to access a certain slice of an investment pie. There are funds that invest exclusively in T-Bills or junk bonds or munis issued only in the state of California. There are also total bond market mutual funds, which take a broad-based approach to bond investing, creating investment exposure to a larger segment of the fixed-income market.
Mutual funds are typically bought directly from the investment firm that manages the fund, through a brokerage account, or with the help of a financial advisor.
A bond ETF is similar to a mutual fund in that it aims to capture a particular part of the market. Where it differs, though, is that once the bond ETF portfolio is constructed, the entire basket of securities trades as if it were one issue on the secondary market, as with an individual stock. In short, that means the underlying securities within the ETF may fluctuate as security prices change, but so will the value of the ETF itself, as it’s bought and sold on the open market.
Where can I buy bonds?
It’s quick and easy to add a bond component to your overall portfolio, once you know where to look. To add a bond component to your investment portfolio, you can:
- Open a brokerage account and buy individual bonds or bond-specific mutual funds or ETFs directly through the account
- Download an investing app like Stash or TD Ameritrade to your smart device to get access to individual bonds or bond-specific mutual funds or ETFs (available offerings vary by the app)
- Talk to a financial advisor, who can execute any buy and sell trades, but can also help you decide whether individual bonds, a mutual fund, an ETF, or something else is best for you
- Buy Treasuries directly through the U.S. Treasury through its site, TreasuryDirect
What’s the bottom line?
The fastest, easiest way for a beginner investor to access the bond market is through a bond-specific mutual fund or ETF, though Treasuries can be bought directly through the U.S. government. Bonds are generally viewed as a low-volatility addition to a portfolio with a healthy amount of diversification. But, as with all investments, bonds do come with inherent risk.
A financial advisor can help if you’re not sure where to start, or just want some guidance as you navigate the not-always-easy-to-understand world of bonds.