How to Buy Bonds: A Guide for Beginners

Bonds are issued by governments, municipalities, and companies as a way to raise money. By investing in bonds, an investor is giving the issuer of the bond a loan for a set period of time. In exchange, the bond issuer pays the investor interest and returns the principal to them when the bond matures at the end of a predetermined period.

Investing in bonds might seem a little mystifying, but bonds can be a way for beginning investors — or any investors for that matter — to help achieve financial goals such as portfolio diversification and earning income. Read on to learn about the different types of bonds and how to invest in them.

Why Invest in Bonds

Essentially, investing in bonds is a method of lending money to a company or government. As investors choose between the different types of investments, there are several reasons they might opt for bonds. Bonds, which are typically fixed income investments, pay interest at regular intervals, such as twice a year, which provides investors with a predictable stream of income. Also, if investors hold the bond to maturity, they receive the entire principal amount (or par value) of the bond. In this way, investors may preserve their savings while investing.

Bonds are also an important tool for building a diversified portfolio. Compared with stocks, bonds are less volatile, so they can potentially help offset some of the risk inherent to stock investing.

However, while bonds are typically considered a less risky investment, it’s still possible to lose money when investing in them if the issuer is unable to fulfill its obligation. In addition, inflation can eat away at bond returns, since fixed returns tend to be worth less during periods of high inflation.

Recommended: Bonds vs. Stocks: Understanding the Difference

Where Can You Buy Bonds?

You can buy bonds in a variety from a variety of different sources, depending on the type of bond you’re interested in.

Federal Government

If you’re 18 or older, you can buy government bonds directly from the federal government through the TreasuryDirect website. The site gives investors access to Treasury bills, notes, bonds, Floating Rate Notes, Treasury Inflation-Protected Securities, and savings bonds.

Brokerage Account

Investors can buy a variety of bonds, including corporate, municipal, and government bonds, through their brokerage account. Bond prices vary depending on transaction fees and markups.

Exchange-traded Fund (ETF) or Mutual Fund

Rather than buying bonds outright, investors can gain access to them by buying shares of ETFs or mutual funds that invest in bonds.

Diversification is one main reason for investing in funds. Because issuers typically sell individual bonds in large units (a single bond might cost $1,000 or more, for instance) the average investor may only be able to purchase a few of them on their own, making it tricky to put together a diversified bond portfolio.

Meanwhile, funds typically hold a diversified basket of bonds that tracks a bond index or a certain sector of the bond market, making it much easier for individuals to diversify. It’s important to note that while the yield of individual bonds is fixed, the yield on bond mutual funds or ETFs can fluctuate over time.


💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

What Type of Bonds Can You Buy?

There are a few basic types of bonds you may consider buying:

Corporate Bonds

Corporate bonds are a type of debt security issued by public and private corporations. Investment banks typically underwrite the debt and issue it on the entity’s behalf. Companies use the money they raise through bond sales for a variety of purposes, such as investing in new equipment, research and development, paying investor dividends, and stock buybacks.

Municipal Bonds

States, cities, and counties issue municipal bonds, sometimes called “munis,” to finance capital expenditures like the building of new roads or bridges. There are three general types of municipal bonds:

•   General obligation bonds aren’t backed by assets, but rather the “full faith and credit” of the issuer. Governments have the power to tax residents to pay bondholders back.

•   Revenue bonds are backed by revenue from a specific source, such as highway tolls. That said, some revenue bonds are “non-recourse” meaning that if the revenue source disappears, bondholders have no claim to it.

•   Conduit bonds are issued on behalf of private entities like hospitals.

US Treasurys

The Department of the Treasury issues U.S. Treasury bonds for the federal government. Investors typically consider Treasurys one of the safest investments, since they have the full faith and credit of the U.S. government backing them.

•   Treasury bills are short-term debt obligations that mature within one year or less. They are sold to investors for less than their face value but they pay their full value at maturity.

•   Treasury notes are longer-term debt securities that mature within 2, 3, 5, 7, or 10 years and pay interest every six months.

•   Treasury bonds mature in 20 or 30 years and pay bondholders interest every six months.

•   Treasury Inflation-Protected Securities, or TIPS, are notes or bonds that adjust payments to match inflation. Investors can buy TIPS with maturities of five, 10 and 30 years, and they pay interest every six months.

Recommended: How to Buy Treasury Bills, Bonds, and Notes

Bond Mutual Funds

A mutual fund is a pool of money that’s invested by an investment firm according to a set of stated objectives. A bond mutual fund focuses specifically on bonds. They may concentrate on one type, such as corporate bonds, or they may contain all types. Unlike traditional bonds, investors do not hold the bond funds for a set period or receive a principal payment at maturity. Rather, the value of the bond fund can fluctuate with market demand. There may also be ongoing fees and expenses associated with owning shares of the mutual fund.

Bond ETFs

Like bond mutual funds, bond ETFs represent a way for investors to pool their money and spread it across many different investments. While investors can only trade mutual funds once a day, they can trade ETFs throughout the day. ETFs may have lower fees than mutual funds.

How to Invest in Bonds

As investors are exploring investing in bonds, it’s important to consider the following factors:

Credit Ratings

Credit ratings are a way to gauge the creditworthiness of companies or governments that issue bonds. The ratings give investors an idea of how likely the bond issuer is to default. Standard & Poor’s, Moody’s, and Fitch are the three private companies that control most bond ratings. The rating system is slightly different at each company, but generally speaking, a mark of AAA represents the highest rated and least likely to default issuers, while C or D denotes the riskiest issuers.

Duration

A bond’s duration is not the same at its term, or maturity. Rather it is a measure of how sensitive a bond’s price will be to changing interest rates. The longer a bond’s duration, the more likely its value will fall as interest rates rise.

Fees

If you buy bonds through a broker, you should expect to pay transaction fees. Brokers typically markup the price of a bond when they sell it to you in lieu of charging a commission. Markups may be anywhere from 1% to 5% of the bond’s original value, though the exact amount can vary based on the type of bond, the size of the transaction, and market conditions. Look for brokerages that have low fees and markups.

Risk Level

Before buying a bond, investors should understand the associated risks, including:

•   Credit risk: The risk that issuers may fail to make interest payments and default on the bond.

•   Interest rate risk: The possibility that changes in interest rate will raise or lower a bond’s value if sold before maturity.

•   Inflation risk: The risk that inflation will decrease the value of bond returns.

•   Liquidity risk: The risk an investor won’t be able to sell their bond when they want to due to low or no demand.

Timing

You might consider matching the maturity date to your investment timeline. For example, if you need your principal in five years to make a down payment on a house, you may not want to buy a 10-year bond. While you could sell the 10-year bond after five years, market conditions could make it less valuable than if you waited until maturity.

The Takeaway

Whether purchased individually or accessed through mutual funds or ETFs, bonds provide a way for investors to diversify their portfolios. They may also be able to help investors develop a stream of income, which can become increasingly important as they move toward retirement.

Before buying a bond, it’s important to research issuers and credit ratings to be sure you aren’t taking on undue risk. In addition, investors will want to make sure that whatever they buy fits into their long-term investment plan.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

FAQ

Are bonds a safe investment?

Bonds are generally considered a less volatile investment than stocks. However, investing in bonds does involve risk. How sound a bond is depends on such factors as the issuer of the bond and whether they are able to fulfill their payment obligations, and the bond’s credit rating. Different types of bonds involve different levels of risk. For instance, U.S. Treasury bonds are considered the safest bonds because they are backed by the U.S. government and have a minimal risk of default.

Is it better to hold cash or bonds?

Whether it’s better to hold cash or bonds depends on your timeline, risk tolerance, and goals. Cash is typically better for short-term needs, while bonds may be better as longer-term investments. Both have pros and cons. Cash could lose its buying power due to inflation, but it’s a completely liquid asset and offers protection against volatile markets. Bonds can provide consistent income through regular interest payments, but they carry the risk of default — if the bond issuer defaults, you could lose some or all of your investment. Consider all these factors to decide what’s right for you.

Will you lose money on a bond if you hold it to maturity?

Generally speaking, when an investor holds onto a bond until maturity, they receive the face value of the bond, which is the amount the issuer agrees to pay at maturity, in addition to the interest received. Those planning to hold until maturity, rather than sell beforehand, may be less concerned about interest rate risk, which is when changes in the interest rate increase or decrease a bond’s value. However, holding a bond to maturity is not risk-free — there is a possibility that the bond issuer could default on the bond or that rising inflation could erode the purchasing power of the bond’s return.

Photo credit: iStock/ILIA KALINKIN