Investing in bonds is a method of lending money to a company or government. Governments, municipalities, and companies issue bonds to investors who are willing to lend them money for a set period of time. In exchange, the issuer pays interest over the life of the loan and returns the principal when the bond “matures” at the end of a predetermined period known as the bond term.
When building a diversified portfolio, many investors want to include a mix of equities (stocks) and fixed income (bonds), since the two securities have different attributes and often behave differently throughout the economic cycle. Here’s a closer look at how bonds work, and how and why to buy them.
Why Invest in Bonds
As investors choose between the different types of investments, there are several reasons they might opt for bonds. Bonds 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 get back their entire principal. In this way, investors can preserve their savings while investing.
Bonds are also an important tool for diversification. Compared with stocks, bonds are less volatile, so they can offset some of the risk inherent to stock investing.
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While investors typically consider bonds a less risky investment, it’s still possible to lose money when investing in bonds, if the issuer is unable to fulfill its obligation. In addition, inflation can eat away at bond returns, since fixed returns are worth less during periods of high inflation.
Where Can You Buy Bonds?
The best way to purchase bonds for you will depend on the type of bond and the bond market exposure that you want.
If you’re 18 or older, you can buy government bonds directly from the federal government through the TreasuryDirect website. The site is available at all times and gives investors access to Treasury bills, notes, bonds, Floating Rate Notes, Treasury Inflation-Protected Securities and savings bonds.
Investors can buy a variety of bonds, including corporate, municipal, and government bonds, through their bank brokerage account. Bond prices vary depending on transaction fees and markups.
An ETF or Mutual Fund
Investors who don’t want to buy bonds directly can gain access to the asset class by buying shares of exchange-traded funds (ETFs) or mutual funds that themselves invest in bonds.
Diversification is the main reason for investing in funds. Because issuers typically sell individual bonds tend in large units (a single bond might cost $1,000) 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.
What Type of Bonds Can You Buy?
There are a few basic types of bonds you may consider buying:
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 entities behalf. Companies use the money they raise through bond sales for a variety of reasons, such as investing in new equipment, research and development, paying investor dividends, and stock buybacks.
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.
The Department of the Treasury issues U.S. Treasury bonds for the federal government. Investors typically consider Treasuries 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.
• Treasury notes are longer-term debt securities that mature within 10 years.
• Treasury bonds mature in 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.
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 focus on one type, such as corporate bonds, or they may contain all types. Unlike traditional bonds, investors don’t get their principal returned with bond mutual funds, and there may be ongoing fees and expenses associated with owning shares of the mutual fund.
Like bond mutual funds, bond ETFs represent a way for investors to pool their money and spread it across a basket of 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 decide which bonds to buy, they may want to consider the following factors:
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.
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. However, you can avoid duration issues by holding the bond to its maturity date.
If you buy bonds through a broker, you should expect to pay transaction fees. Brokers typically mark up 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 bonds original value. Look for brokerages that have low fees and markups.
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.
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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.
Whether purchased individually or accessed through mutual funds and ETFs, bonds provide an important way for investors to diversify their portfolios. They can also help investors develop a reliable stream of income, which can become increasingly important as they move toward retirement.
Before buying a bond, you should research issuers and credit ratings to be sure you aren’t taking on undue risk. And above all, you should be sure that whatever you buy fits into your long-term investment plan.
If you’re interested in adding bonds to your portfolios via exchange-traded funds, a great way to start is by opening an account on the SoFi Invest brokerage platform. With SoFi Active Investing, you can buy and sell ETFs and trade traditional company stocks and fractional shares.
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