How to invest in bonds

Bonds can play a vital role in any investment portfolio. Bonds yield income, are often considered less risky than stocks and can help diversify your portfolio.

Jump to:

• What types of bonds are there?
• What are some tips for investing in bonds?
• What are the benefits of investing in bonds?
• What are the risks associated with investing in bonds?
• Where can I buy bonds?

What types of bonds are there?

Bonds – also known as fixed income instruments – are used by governments or companies to raise money by borrowing from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the investment, with interest, over a certain period of time.

Certain types of bonds – corporate and government bonds – are rated by credit agencies to help determine the quality of those bonds. These ratings are used to help assess the likelihood that investors will be repaid. Typically, bond ratings are grouped into two major categories: investment grade (higher rated) and high yield (lower rated).

The three major types of bonds are corporate, municipal, and Treasury bonds:

• Corporate bonds are debt instruments issued by a company to raise capital for initiatives like expansion, research and development. The interest you earn from corporate bonds is taxable. But corporate bonds usually offer higher yields than government or municipal bonds to offset this disadvantage.
• Municipal bonds are issued by a city, town or state to raise money for public projects such as schools, roads and hospitals. Unlike corporate bonds, the interest you earn from municipal bonds is tax-free. There are two types of municipal bonds: general obligation and revenue.
  • Municipalities use general obligation bonds to fund projects that don't produce income, such as playgrounds and parks. Because general obligation bonds are backed by the full faith and credit of the issuing municipality, the issuer can take whatever measures necessary to guarantee payments on the bonds, such as raising taxes.
  • Revenue bonds, on the other hand, pay back investors with the income they're expected to create. For example, if a state issues revenue bonds to finance a new highway, it would use the funds generated by tolls to pay bondholders. Both general obligation and revenue bonds are exempt from federal taxes, and local municipal bonds are often exempt from state and local taxes as well. Revenue bonds a good way to invest in a community while generating interest.
• Treasury bonds (also known as T-bonds) are issued by the U.S. government. Since they’re backed by the full faith and credit of the U.S. government, treasury bonds are considered risk-free. But treasury bonds don’t yield interest rates as high as corporate bonds. While treasury bonds are subject to federal tax, they’re exempt from state and local taxes.

Other types of bonds

• Bond funds are mutual funds that typically invest in a variety of bonds, such as corporate, municipal, Treasury, or junk bonds. Bond funds usually pay higher interest rates than bank accounts, money market accounts or certificates of deposit. For a low investment minimum ranging from a few hundred to a few thousand dollars, bond funds allow you to invest in a whole range of bonds, managed by professional money managers. When investing in bond funds, keep in mind:
  • Bond funds usually include higher management fees and commissions
  • The income on a bond fund can fluctuate, as bond funds typically invest in more than one type of bond
  • You may be charged a redemption fee if you sell your shares within 60 to 90 days
  • Bond funds that are leveraged have greater risk
• Junk bonds are a type of high-yield corporate bond that are rated below investment grade. While these bonds offer higher yields, junk bonds are named because of their higher default risk compared to investment grade bonds. Investors with a lower tolerance for risk may want to avoid investing in junk bonds.

What are some tips for investing in bonds?

When investing in bonds, it’s important to:

1. Know when bonds mature. The maturity date is the date when your investment will be repaid to you. Before you commit your funds, know how long your investment will be tied up in the bond.
2. Know the bond’s rating. A bond’s rating is an indication of how creditworthy it is. The lower the rating, the more risk there is that the bond will default – and you lose your investment. AAA is the highest rating (using the Standard & Poor’s rating system). Any bond with a rating of C or below is considered a low quality or junk bond and has the highest risk of default.
3. Investigate the bond issuer’s track record. Knowing the background of a company can be helpful when deciding whether to invest in their bonds.
4. Understand your tolerance for risk. Bonds with a lower credit rating typically offer a higher yield to compensate for higher levels of risk. Think carefully about your risk tolerance and avoid investing solely based on yield.
5. Factor in macroeconomic risks. When interest rates rise, bonds lose value. Interest rate risk is the risk that rates will change before the bond reaches its maturity date. However, avoid trying to time the market; it’s difficult to predict how interest rates will move. Instead, focus on your long-term investment objectives. Rising inflation also poses risks for bonds.
6. Support your broader investment objectives. Bonds should help diversify your portfolio and counterbalance your investment in stocks and other asset classes. To make sure your portfolio is balanced appropriately, you may want to consult an asset allocation calculator based on age.
7. Read the prospectus carefully. If you’re investing in a bond fund, be sure to study the fees and analyze exactly what types of bonds are in the fund. The name of the fund may only tell part of the story; for example, sometimes government bond funds also include non-government bonds.
8. Use a broker who specializes in bonds. If you’re purchasing individual bonds, choose a firm that knows the bond market. Use FINRA BrokerCheck to help find trustworthy professionals that can help you open a brokerage account.
9. Learn about any fees and commissions. Your broker can help break down the fees associated with your investment.

What are the benefits of investing in bonds?

Bonds offer a host of advantages:

• Capital preservation: Capital preservation means protecting the absolute value of your investment via assets that promise return of principal. Because bonds typically carry less risk than stocks, these assets can be a good choice for investors with less time to recoup losses.
• Income generation: Bonds provide a fixed amount of income at regular intervals in the form of coupon payments.
• Diversification: Investing in a balance of stocks, bonds and other asset classes can help you build a portfolio that seeks returns but is resilient through all market environments. Stocks and bonds typically have an inverse relationship, meaning that when the stock market is down, bonds become more appealing.
• Risk management: Fixed income is broadly understood to carry lower risk than stocks. This is because fixed income assets are generally less sensitive to macroeconomic risks, such as economic downturns and geopolitical events.
• Invest in a community: Municipal bonds allow you to give back to a community. While these bonds may not provide the higher yield of a corporate bond, they often are used to help build a hospital or school or that can improve the standard of living for many people.

What are the risks associated with investing in bonds?

As with any investment, buying bonds also entails risks:

• Interest rate risk: When interest rates rise, bond prices fall, and the bonds that you currently hold can lose value. Interest rate movements are the major cause of price volatility in bond markets.
• Inflation risk: Inflation is the rate at which the price of goods and services rises over time. If the rate of inflation outpaces the fixed amount of income a bond provides, the investor loses purchasing power.
• Credit risk: Credit risk (also known as business risk or financial risk) is the possibility that an issuer could default on its debt obligation.
• Liquidity risk: Liquidity risk is the possibility that an investor might wish to sell a bond but is unable to find a buyer.
• Stocks tend to earn more money than bonds. In the period 1928-2010, stocks averaged a return of 11.3%; bonds returned on average 5.28%.
• Bonds freeze your investment for a fixed period of time. For example, if you buy a 10-year-bond, you can’t redeem it for 10 years. This creates the potential for your initial investment to lose value. Stocks, on the other hand, can be sold at any time.

You can manage these risks by diversifying your investments within your portfolio.

Where can I buy bonds?

Stocks are traded on a centralized market, meaning that all trades are routed to one exchange and are bought and sold at one price. Unlike stocks, bonds aren’t publicly traded on an exchange. Instead, bonds are traded over the counter, meaning that you must buy them from brokers. However, you can buy U.S. Treasury bonds directly from the government.

Because bonds are not traded on a centralized market, it can be difficult for investors to know whether they’re paying a fair price. While one broker may sell a bond at a premium (above face value, to gain a profit), another broker’s premium might be even steeper.

The Financial Industry Regulatory Authority (FINRA) regulates the bond market. FINRA posts transaction prices as the data becomes available. The data may lag the market, however, making it difficult to know what constitutes a fair price at the time you wish to invest.