Bonds are an often misunderstood investment, but they can be a key element in a diversified portfolio. If you’re learning how to invest money, understanding how bonds work is important.
Whether you’re investing in individual bonds or a bond mutual fund or an exchange-traded fund (ETF), learning about bonds can help you evaluate this investment and determine if it might fit within your overall strategy.
How bonds work
When you invest in stocks, you’re buying shares of a particular company. As a shareholder, you participate in any gains or losses in the stock’s price and receive dividend payments if the company pays dividends.
Bonds, on the other hand, are a debt instrument. The issuer of the bond is borrowing money via the sale of their bonds. In return, the issuer agrees to pay interest on the bonds and will ideally repay the face value of the bond at the bond’s maturity date, assuming they don’t run into any financial difficulties — more on this in a moment.
Bonds could be a key part of an investment portfolio for investors at all stages, whether you’re a beginner investor or nearing retirement.
How to invest in bonds
Investing in bonds through a bond ETF or mutual fund might offer advantages. Bond funds typically offer professional management and a diversified portfolio of individual bonds wrapped into one managed fund. Even when funds specialize in a particular type of bond, the diversification they offer could help provide you with some protection against risk.
You might opt to purchase individual bonds through a broker or trading platform, and purchases can be made online in most cases. If you are looking to buy a bond that is thinly traded you may have to find a bond broker who specializes in that particular bond. “Thinly traded” means that there is not much trading activity for this bond.
If you choose to, you could also purchase Treasury bonds and bills through the federal government's Treasury Direct site. Large institutional investors like pension funds and others place bids for the securities they want to buy for the upcoming auction of Treasuries, which occurs at regular intervals during the year. Individuals can then place an order for a set dollar amount of the type of Treasury security they wish to purchase. The price and interest at which you purchase these securities is the average of the bids placed at auction.
4 types of bonds
1. Municipal bonds
Municipal bonds, also known as munis, are issued by states, municipalities, cities, or counties to finance day-to-day operations or capital expenditures such as roads, schools, sewer systems, and other projects. Munis typically fall into one of two categories: general obligation and revenue bonds. General obligation bonds are backed by the “full faith and credit” of the state or local government issuing the bonds. Revenue bonds are all or in part backed by revenue from the project they were issued to fund; for example, the highway tolls collected for a new road financed by the bonds.
Any interest payments you receive from a municipal bond are free from federal taxes, which can make these bonds an attractive option for higher-income investors.
2. Corporate bonds
A corporate bond is a debt obligation issued by a corporation. These bonds typically pay interest on a semi-annual basis, and those interest payments are typically taxable. If you choose to invest in corporate bonds, you are essentially loaning money to the issuing corporation. They may use that money for general corporate purposes or to fund a specific company project.
The interest rate offered by the corporation when issuing the bonds will be a function of the company’s ratings for financial strength, the number of years until the bonds mature, and the level of interest rates on comparable bonds.
3. U.S. Treasury securities
Bonds and shorter-term Treasury bills are generally considered some of the most low-risk securities in the world because they’re issued by the U.S. government. If you choose to invest in these government bonds, any interest you earn is typically exempt from state income taxes but subject to federal taxes.
4. Mortgage-backed securities
Mortgage-backed securities are bonds backed by pools of mortgages from Ginnie Mae, a U.S. governmental agency, and government-sponsored organizations like Fannie Mae and Freddie Mac. With these bonds, Ginnie Mae guarantees investors receive timely payments, and the others also offer some guarantees as well.
When you invest in this type of bond, you typically receive payments that consist of part principal and interest based on the repayment of the underlying mortgages. The biggest risk to you if you go this route is the prepayment of the underlying mortgages in situations where interest rates are dropping. When the mortgages are prepaid, it generally means that interest rates are heading lower, which could limit your options if you’re looking to reinvest in a high-yielding alternative with a comparable level of risk.
How to trade bonds: 3 common strategies
When it comes to trading individual bonds, there are several strategies that you can use, depending upon your needs and situation. Some popular strategies include:
Buy and hold
If you employ a buy and hold strategy, it means that you would buy a number of individual bonds with the objective to hold each of the bonds purchased until their maturity. Under this scenario, you’d typically buy several bonds and hold them until they mature.
During the holding period, you’ll generally receive periodic interest payments, creating a stream of fixed income. Different bonds may pay interest at different times during the year. For example, one bond might pay interest during the first and third quarters of the year. Another might make payments during the second and fourth quarters. Taking this into consideration could potentially help you spread your interest income over different periods during the year, assuming the bond issuers make their interest payments on time.
When a bond matures, it typically pays out the par or face value of the bond. In many cases, this value equals $1,000 per bond. If you buy bonds when they are newly issued, you will generally pay the face value of the bonds. If you buy or sell bonds on the secondary market you will typically pay more or less than the par value. If you hold the bond until maturity, you will generally receive the face value from the bond issuer.
Creating a bond ladder involves buying several bonds with different maturity dates. When you ladder bonds like this, you could potentially create a continual stream of cash flow from the redemptions which occur at different times.
For example, you might own bonds that mature in six months, a year, two years, three years, and five years. This means that you could potentially receive cash from the redemption of the bond at each of these intervals. You might then use this cash for other purposes, including investing in additional bonds or making another type of investment.
ETFs and mutual funds
For many investors, investing in bond ETFs and mutual funds can be a smart choice. Many online brokers such as Stash allow investors to easily purchase bond ETFs. Custodians such as Fidelity, Vanguard, Schwab, and others offer a wide range of both bond ETFs and mutual funds that investors can choose from.
Investing in bond ETFs and mutual funds can make the process of ownership much simpler than if you were to buy individual bonds. These funds offer professional management in several bond categories and could potentially alleviate much of the hassle that comes with owning individual bonds, especially for smaller investors.
Things to consider when you invest in bonds
Bonds could potentially be a beneficial part of your investment portfolio as they provide diversification away from stocks and may offer a measure of protection against market volatility. But it’s important to keep in mind that the factors that influence the pricing of bonds are different than those that impact the movement of stocks. It’s primarily interest rates that impact the bond market. If rates move higher, the price of a bond will generally move lower, all else being equal. So there's some interest rate risk to keep in mind if you choose to invest in bonds.
Other factors include the credit risk of the bond issuer and the time to maturity. Riskier bonds might typically pay a higher level of interest. Bonds with a longer maturity also typically carry a higher interest rate due to the risk of what can occur to the issuer, interest rates, and other factors over a long period of time.
There are additional things to consider with bond investing, too.
Bonds with a high yield, sometimes referred to as junk bonds, are often very risky for investors. While the bond yield might be higher with these than most other investment-grade bonds of similar maturity, that’s often due to the lower credit quality of the issuer. The bond issuers could be at a higher risk of default, and in the event of a default, the issuer may not be able to make interest payments or redeem the bonds to bondholders when they mature.
If you’re thinking about investing in bonds, credit ratings are an important consideration, especially with individual bonds. Companies or municipal bond issuers receive ratings from credit rating agencies, including Standard & Poor’s, Moody’s, and Fitch. While issuers with high credit or bond ratings can certainly default, these credit ratings are often a good indicator of the creditworthiness of the issuer, good or bad.
Broker expertise and commissions
When buying bonds through a broker, it makes sense to vet the broker as to their experience and any regulatory issues. Unlike stock trading, which is fairly transparent, buying bonds often involves a spread between the price the bond broker pays for the bond and what they charge you. This spread is a major source of revenue for them. It makes sense to compare the spread on the same bond at several brokers, especially if you are new to buying individual bonds. It’s also a good idea to compare the commissions charged by the bond brokers you may be considering, as they can vary widely as well.
Liquidity can be another issue when trading individual bonds. Bonds are traded on the secondary market on an over-the-counter (OTC) basis, meaning there needs to be a willing buyer and seller. If you are interested in selling bonds on the secondary market, treasuries and widely-traded corporate names tend to be fairly liquid.
It’s important to note that the secondary market for bonds works differently than the stock market. Stocks are very liquid and can generally be bought or sold with the click of a mouse. OTC markets tend to be less liquid and less transparent than organized exchanges like the New York Stock Exchange. This can potentially increase the costs of trading as well as the risk to both parties in the transaction. It can also make some bonds illiquid, resulting in high spreads between what a bond might seem to be worth and what the seller actually receives.
For these and a host of other reasons, owning bonds through an ETF or a mutual fund is the preferred method for many investors.
Is trading bonds profitable?
Bond trading could potentially be profitable, but investors need to understand the factors that influence bond prices such as interest rates, credit quality, and others. Bonds may offer a steady stream of income to investors, though all investments come with a level of risk. Investing in a bond mutual fund or ETF may help offset some of your risk because both options offer instant diversification.
Can you lose money investing in bonds?
You can lose money investing in bonds. If you hold a bond and then interest rates rise, the price at which you could sell the bond might decline. Rising interest rates can also impact the price of the underlying bonds in a mutual fund or an ETF, causing the value of the fund to decline as well. If you needed to sell at these lower levels, you could incur a loss.
Are bonds a better investment than stocks?
Bonds are not a better or worse investment than stocks; they are simply different and serve a different purpose. They can both be part of a diversified portfolio, depending on your individual investing preferences and goals.
The bottom line
Stocks and bonds are different and are impacted by different market and economic factors. When you invest in stocks, you own equity in a company. But when you invest in bonds, you’re lending money to the issuer of the bond. You are paid interest and may receive the face value of the bond when it matures, assuming the issuer is financially stable.
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