Building an investment portfolio is a smart and practical way to grow your wealth. But given how unpredictable the economy can be, you need to protect your funds by diversifying your investments. One way to achieve that is by buying bonds.
But, what is a bond exactly? And how does it work as an investment?
Other forms of investments, such as stocks and annuities, provide sources of income for a certain period while bonds offer a more reliable long-term cash flow. Compared to stocks, bonds tend to move in a way that balances portfolio performance. For example, when the economy is weak, it may increase in value while stocks go in a downward spiral.
Despite the advantages that bonds offer, a lot of investors are not comfortable buying them. In this article, we’ll take a closer look at how bonds work and how they fit into your portfolio.
How Bonds Work
A bond is an investment option in which you, as the investor, provide loans to borrowers. It comes with the expectation that you will get your money back plus interest within the term length. It's also a form of fixed-income investment; meaning, you have a solid idea of the return that you’ll receive before making a purchase.
For example, bonds can be issued (or put up for sale) by entities, in this case, either the government or private companies. You loan your money to them (that is, you buy the bonds), and they pledge to repay you in full along with regular interest payments before the end of the term.
Even when interest rates are low, you are presented with several options to build a portfolio that meets your financial goals.
The time a bond is first sold is referred to as the issue date, while the one its principal is due is called the maturity date. Between these two dates, the issuing entity makes regular payments, called coupons.
Typically paid out semi-annually on individual bonds, a coupon is the annual interest rate paid on the bond issuer’s borrowed money. It is always connected to a bond’s face value.
For example, you invest $5,000 in a six-year bond with a coupon rate of 5% per year, semi-annually. If you decide to hold the bond until it matures, you will get 12 coupon payments of $125 each for a total of $1,500.
A bond's coupon rate is a fixed payment – that means that it will remain the same for the bond's entire lifetime.
Coupon payments on bonds are often deposited directly into the investor’s bank or brokerage account. They’re generally made every six months, depending on the date of the bond’s issuance. For example, a bond first sold on December 15 pays interest on the 15th of June and December every year until maturity.
How Interest Rates Affect Bond Prices
The prevailing market interest rates have a major influence on bond prices. When market interest rates rise, newly issued bonds come with a higher interest rate, providing more income to investors. When rates go down, those bonds will have a lower interest rate as well, making them not as attractive as older bonds.
It should be noted, though, that in a high-interest rate environment, pre-existing bonds can’t increase their rates the way the new, higher-interest ones do. Their rates remain as per the original terms.
Where To Buy Bonds
Bonds can be bought and sold over the counter, but you must buy them from brokers. Take note, however, that bond prices may vary from brokerage to brokerage due to transaction fees. To give you a ballpark figure, bonds sold on the over-the-counter market are usually higher than $5,000 at a time.
You can also buy treasury bonds directly from the U.S. government. A program was set up on the TreasuryDirect website so that investors can directly purchase government bonds without paying a fee to a broker or middleman.
Why Do Governments And Corporations Issue Bonds?
The U.S. government and private entities sell bonds for various reasons. The Federal Government, for example, may sell government bonds to pay for the growing national debt. On the other hand, a city may sell bonds to raise money to build new infrastructures, such as a new hospital, school, or bridge.
Meanwhile, businesses tend to take loans to support their operations, expand into new markets, and invest in new technology. But often, the funds that banks provide aren’t enough. One other way for corporations to raise the necessary amount is by becoming a bond issuer.
Types Of Bonds
The first step to bond investment is to know the different types of bonds available to you. Each one has different sellers, buyers, and purposes. They also have varying levels of risk-versus-return factors. Some of the most common types of bonds are the following.
Issued by the Treasury Department, U.S. Treasury bonds set the interest rates for all long-term, fixed-rate bonds. They are offered for two primary reasons. One is to pay the national debt and the other is to influence economic growth. The issuance of these bonds can increase or decrease the amount of money available to banks.
Since the U.S. government backs them, treasury bonds have the lowest risk. Almost all institutional investors, corporations, and wealth funds buy them. But since these bonds provide a safety net, they have lower interest rates compared to bonds issued by corporations.
How To Acquire Treasury Bonds
The Treasury Department offers Treasury bonds regularly scheduled auctions. You can purchase them through a bank or broker for a fee or directly from the TreasuryDirect website.
Buying directly from the Treasury lets you avoid paying commission fees. Before making any transactions through the website, you must apply for an account through the application portal.
Being a TreasuryDirect account holder lets you participate in the auctions, where you have two bidding options: competitive and noncompetitive.
Competitive bidding: Bids are usually submitted by large-scale investors, such as foreign countries and institutional investors. The bidders are limited to receiving no more than 35% of the total amount of securities available to the public.
Noncompetitive bidding: Small investors and individuals may submit their bids here. While they are guaranteed to receive securities, the amount that may be sold to them is only up to $5 million.
Treasury bonds have maturity periods that range from 10 to 30 years. Their price and yield are determined at the auction. Meaning, the amount you pay may be higher, lower, or equal to the bond’s face value. The lowest face value on a bond is $1,000, while the minimum bid accepted is $100, with increments of $100 up to the face value.
Municipalities often issue bonds when the amount they collected through taxes is not enough to fund their projects. One great thing about such bonds is that not all of them require you to pay federal income taxes on the interest earned. Because of that, they have lower interest rates compared to taxable bonds.
Before investing in a municipal bond, be sure that the bond issuer can meet its financial obligations. They should have a record of being able to deliver interest and principal payments on time. You can check this through official statements or circulars by the issuing municipality.
The maturity dates of municipal bonds vary in years. Short-term bonds reach maturity in one to three years, while long-term bonds take more than a decade.
How To Buy Municipal Bonds
Municipal bonds are sold directly from registered municipal bond sellers. You can also buy indirectly through a municipal bond fund or a dealer in the secondary market, such as a financial advisor or a bank.
When you purchase municipal government bonds from a registered bond issuer, there are no fees or markups you need to worry about. But keep in mind that you must have an account with the bank that’s facilitating the offering.
Typically, the face value is $1,000, but if you’re buying from a traditional bank or brokerage firm, the price may include a markup due to the dealer’s cost. You may also be charged an additional commission if you’re working with a representative or firm to look for bonds for you or to manage the transaction.
Issued by public and private corporations, these bonds have higher rates and returns because they are riskier than government-backed bonds. Maturity periods range from one to thirty years. Bonds with a maturity of less than one year are referred to as corporate paper or short-term financing. They are usually held by large financial entities, such as banks and mutual funds, instead of individual investors.
These bonds are great for those seeking additional income streams in hopes of offsetting their higher-risk investments while earning interest over a period of time. One drawback, however, is that you have to pay federal income tax on the interest earned.
On the plus side, corporate bonds offer more options to choose from. Some of the subcategories include the following.
These are types of savings account that allow you to put your money away for some time in return for a fixed amount of interest rate. While the interest rates are attractive, you won’t have access to your money for the entire bond term duration.
Since the interest rate you’re offered upon opening the account stays the same for the bond’s duration, you can determine how much interest you’ll earn. If you decide to let your money remain untouched for an extended period of time, you have a greater chance of receiving a higher interest rate.
Compared to fixed-rate bonds, these corporate bonds tend to shift their interest rates at least once every year. They have a floating or variable coupon rate; if the interest rates rise or fluctuate, the coupon rate adjusts accordingly.
Also known as a discount bond, this type is generally bought at a price lower than its face value, which is repaid at the time of maturity. It doesn’t involve periodic payments or “coupons.” That’s why it’s called a zero-coupon bond. When the bond matures eventually, the investor receives its face value. Examples of zero-coupon bonds include U.S. Treasury bills and savings bonds.
How To Buy Corporate Bonds
Corporate bonds can be purchased as new issues or secondary market bonds. New issues referred to freshly created bonds and are provided through the primary market for a fixed initial offering price. Meanwhile, the secondary market options are pretty much leftovers of the primary market.
All new issue corporate bonds come with a per-unit value or face value of $1,000. You can buy them through the investment bank that manages the issuing company’s offering.
Older corporate bonds are available on the secondary market, where they are sold over the counter, similar to OTC stocks. Depending on the interest rate, bonds on the secondary market may cost around $1,000 per unit. In both the primary and secondary markets, corporate bonds may come with a minimum of five units or $5,000.
Bond Mutual Funds
Another way you can invest in bonds is through bond mutual funds. Bond mutual funds pool money from different investors to be managed by an investment professional. Since you’re buying shares of a diversified managed portfolio of bonds, the overall risks are reduced.
What makes bond funds attractive is that they can be tied to retirement accounts and be used to offset market uncertainty. Although they often deliver lower returns, they provide guaranteed interest payments and preserve your capital until the maturity date.
Any interest, dividends, or capital you gain from a bond fund can be paid or reinvested back in the fund. The fund manager may also add and sell bonds from the fund. Since they are bought and sold regularly, the funds have no maturity date.
Aside from reinvesting the dividends, you have the option to receive monthly payouts. This provides you with a steady stream of cash if you wish to take advantage of the income benefits of bonds.
Unit Investment Trust (UIT)
If you’re not sure about choosing the right bonds to buy, you may consider exploring a unit investment trust. With a UIT, you’d know exactly how much you’ll earn when the bonds mature. You earn interest within the life of the trust both on your initial investment and on the trust’s income.
The bonds in the trust are fixed until the amount you initially invested is ultimately returned to you when the bonds reach maturity. For your convenience, you can hire an investment professional to manage the bonds, but they cannot sell or buy new bonds.
Why Buy Bonds
Bonds offer a variety of advantages when you add them to your investment portfolio. Regardless of the types of bonds you choose to invest in, you will likely gain the following benefits.
One practical reason to invest in bonds is to benefit from the income opportunity they offer. Since most bonds come with a fixed interest rate, they provide investors with regular semiannual payments and lower risk. This offers peace of mind and predictability in terms of cash flow and return. That’s something most other investment options, even stocks, cannot provide.
While all investments come with risks, bonds are considered less risky than others. Not all investments, including stocks, offer to repay your money the way bonds do at maturity.
A lot of investors diversify among various assets to reduce the risk of low or negative returns on their portfolios. Bonds play a crucial role in most portfolio diversification. Since the value of bonds tends to fluctuate less than stocks, they can ride out the swings in your portfolio and dampen any adverse effects.
Although there are types of bonds that pay taxable interest, some are still tax-exempt. For one, municipal bonds are federally tax-free, and if you reside in the state of issue, they are also state tax-free. Interest on federal government securities, such as Treasury bonds, is exempt from state and local taxes as well.
What Are The Risks In Buying Bonds?
There’s a lesser risk when buying than stocks and other investments because the issuers are under a legal obligation to repay the investors. However, bond issuers can go out of business. If they do, bondholders lose their entire investment.
Defaulting is another bond risk. This is when the issuer fails to pay the interest payments or the principal to the investor. This usually happens when the company becomes insolvent or when it’s taken on more debt than it can repay.
Interest rate risk is another challenge that comes with bond investment. When market interest rates rise, and other companies start issuing bonds at higher interest rates, your bonds may become less attractive to investors. That could result in a drop in the bond’s price.
What’s The Difference Between A Stock And A Bond?
Stocks and bonds provide two different types of investment opportunities. Both have certain features that either work for or against you. Understanding those features can help you use stocks and bonds strategically to maximize returns and balance your investment portfolio.
Debt Versus Equity
When you buy bonds, you’re loaning money to the bond issuer. In effect, you are a creditor of the company, city, or government. With bonds, you are purchasing debt or credit instruments in units of $1,000 in face value.
When you buy stocks, you’re purchasing a small percentage of the company. That means you are a shareholder or part-owner of the company. Generally, valued under $100 and referred to as equity, stocks are your proof of ownership.
Risk Versus Safety
Bonds are expected to repay the principal amount at maturity and pay interest every six months. The interest amount depends on the credit quality of the issuer. The better their credit, the more likely you’ll receive your principal back at maturity in addition to timely interest payments. This is why bonds have a lower risk profile compared to stocks.
As a shareholder, you participate in the success or failure of a company. In other words, your stock will fluctuate in price depending on the company’s market performance. That is why stocks are considered riskier than bonds.
Balancing Your Portfolio
A balanced portfolio is composed of both stocks and bonds. The ratio between the two may vary depending on the investor’s age and risk tolerance. In general, financial advisors recommend investing more in bonds the closer you get to retirement. That will offset the risk of having your nest egg decimated in the event of a market crash.
Unlike stocks, where prices are influenced in the long term by a company’s growth and profitability, bond prices are driven by interest rates, the borrower’s creditworthiness, and the investors’ market sentiment.
Tips For Investing In Bonds
Investing in bonds may be an excellent financial move, but that doesn’t mean everything will be smooth sailing. Like any investment, there will be challenges along the way. To help you out, here are some tips that you should keep in mind.
Learn About Bond Maturity
As with ordinary loans, the maturity date refers to the date when the investment will be repaid to you. Before committing your funds, be sure that you know how long your investment will be tied up in the bond.
Check The Bond’s Rating
A bond’s rating indicates its creditworthiness. The lower its credit rating, the higher the risk that it will default, which means you’ll lose your investment.
Based on the Standard & Poor’s system, AAA is the highest rating. Bonds with a grade of C or below are considered junk bonds and they have the highest risk of default.
Diversify And Manage Risk
Buy bonds of different maturities and issuers to manage risk. It will allow you to control the risk better and have a hedge if an issuer suffers financial difficulty.
Also, when you choose various types of bonds, from corporate to municipal bonds, you’ll have protection if any problems arise in any of those sectors. Regardless of what type you plan to buy, be sure that the issuer is financially sound and in good standing.
Understand Your Risk Tolerance
To compensate for the high levels of risk, bonds with lower credit ratings tend to offer higher yields. While that can be tempting, consider your risk tolerance carefully. What level of uncertainty can you handle? It’s also best if you avoid investing based solely on yield.
Buy And Hold
The most popular bonds investment strategy, buy and hold, let the investors keep their money intact even as it earns them interest. When you invest in bonds, buy and hold them until they reach maturity to collect the interest.
Short-term bonds take only a couple of years to mature, while long-term bonds have maturities of 10-30 years. Typically, the longer the maturity period, the higher the total interest payments you receive from the bond.
Bonds can play a crucial part in building an investment portfolio with a good balance between risk and returns. They also help when it comes to generating income and diversifying your portfolio.
If you’re looking to invest in bonds for the first time, navigating the market can be intimidating. With the information in this article, you should be able to learn more about bonds, how they work, and why you might want to consider adding them to your portfolio.
Ready to make a smart and practical investment? Contact Wesley Mortgage, LLC for more information on buying bonds. We can help you make better investments!