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How to buy bonds

Investing in bonds can be a way to minimize risk and diversify your portfolio.

Financial planners recommend you devote a portion of your portfolio to bonds and other fixed-income investments to protect against market volatility. But what are bonds exactly?

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What are bonds?

A bond is a loan investors make to corporations, municipalities, governments or other entities. Every bond has a term or time frame. Throughout this time frame, the borrower makes periodic interest payments to the investor. These payments can be fixed, meaning you know how much interest you’re getting each period. Or they can be variable, meaning they can change throughout the term. But at the end of the term, also known as the maturity date, the borrower agrees to pay back your principal. This is the amount of money you purchased the bond for.

It sounds simple, but bond investing takes careful analysis, and there are some pitfalls you should avoid.

Pros and cons of bonds

Like any investment, bonds have their own set of pros and cons:

Pros

  • Steady, fixed-income investment
  • Higher yield than savings accounts
  • Could provide tax benefits
  • May offer regular interest payments
  • Help fund causes you want to support
  • Less risky than stocks
  • Clear risk ratings

Cons

  • High minimum investment (Usually $1,000)
  • Broker fees if you want to buy or sell on the secondary market
  • Less liquidity if you need access to cash
  • Lower returns than stocks and other investments
  • Bond prices fall when interest rates increase
  • Risk of issuer defaulting

Types of bonds

Government bonds
Corporate bonds

You have a few different options when investing in bonds. Each choice has its own risk and reward potential, making it important that you compare bonds carefully before deciding which ones to buy.

Government bonds

Government bonds are used to generate money to run governments and pay down debt. There are different types of government bonds.

US Treasuries

These types of securities are issued by the federal government. Interest earned from all US Treasury securities are exempt from state and local income tax. These securities are considered among the safest investments in the world and are extremely low-risk. But they pay very low interest rates as a result.

Municipal bonds

Municipal bonds are issued by states, cities, counties and local governments. Munis are usually exempt from federal income tax. They’re also exempt from state and local taxes if you live in the state where the bond was issued.

Corporate Bonds

A corporate bond is issued by a company. You can think of it as an I.O.U. that companies sell to investors. In return, the company agrees to make regular interest payments and pay back the amount you paid at the end of the term. Corporate bonds usually have higher interest rates than government bonds but are also riskier — if the company fails, you may not get all your money back.

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How to buy bonds

There are many ways you can invest in bonds, with some being easier and less expensive than others. We’ll break it down for you.

Through a bond fund.

A bond fund invests in a variety of bonds offering instant diversification. Investing in a bond fund is also typically less expensive than buying individual bonds, which typically sell in $1,000 increments. A share of some of the top performing bond funds can go for less than $20. Bond funds make regular interest payments or dividends to investors. There are two main types of bond funds: bond ETFs and bond mutual funds. You can buy shares of bond funds through most online brokerages.

Directly from the federal government.

You can buy government bonds through the Treasury Direct site. But it may be cheaper to buy the same government bond through an online broker.

Through the primary bond market.

This is one of the most difficult ways to invest in new corporate bonds. You typically need a relationship with the investment bank or financial institution working with the company to bring its bonds to market.

How to evaluate bonds

While many financial advisors consider bonds to be low-risk investments in the securities universe, they’re not bulletproof. Luckily, credit rating agencies exist. The three main ones are Standard & Poor’s, Moody’s and Fitch. These organizations evaluate governments, municipalities and corporations to rate their bonds. It works like a school-paper grading system with AAA being the highest. From there, it drops to a D.

Investors typically group bonds among two different categories.

Investment-grade bonds.

These bonds have a high credit rating (BBB-/Baa3) or higher, which suggests that the company is in a relatively strong financial position to repay the bonds.

High-yield (“junk” or “non-investment grade”) bonds.

These bonds have a lower credit rating (BB/Ba2 or lower), which indicates the bond issuer can be in a tough financial position to meet its debt obligations. However, they generally pay higher interest rates in exchange for the increased risk.

Are bonds safe?

Government bonds are considered to be very safe, but there are bond options that can carry a high level of risk if you aren’t careful. They are typically less volatile than other types of investments, such as shares, but it’s still possible to lose money with government-issued debt. These securities do come with a credit rating, but you will need to consult with a licensed financial advisor in order to access that type of information.

How are bonds valued?

A bond’s capital value can increase or even decrease before the maturity date based on the current interest rates. The amount of interest accrued since the last payment will also have an effect on the value of a bond. If interest rates drop, you’ll see an increase in the value of your bonds, whereas if they rise, the value of your securities will drop as a result. These fluctuations are only relevant if you’ve invested in floating-rate debt as opposed to fixed-rate because the interest varies in line with the benchmark interest rate. This investment has the potential to earn higher returns, but there is also a risk of lower returns if the interest rate drops.

How do I choose a bond to invest in?

If you are interested in diversifying your investments this way, you’ll first need to decide which type of bond is right for your financial strategy:

Individual bonds

Type of bondIssued byRiskRewardPurposeTaxes
TreasuryGovernmentVery lowVery lowFinance US government debt, capital expenditures, etc.Very low
MunicipalCities, states, countiesLow-mediumLow-mediumFinance municipal purchases and public projectsTax-exempt at federal level, exempt from state and local if issued by your home state.
CorporateCompaniesHighHighFinance growth, debt, capital expenditures, researchTaxable at federal, state and local levels

Bond funds

If you’d like to diversify your investment even further, you can invest in something called a bond fund. A bond fund is a mutual fund or ETF that is comprised of multiple bonds with varying risk levels, maturity dates and yields. This provides instant diversification and allows investors to participate in multiple bonds without paying for individual transaction fees. Instead, you’ll pay an annual expense ratio which also gives you access to a professional portfolio manager that will do all the research, analysis and management for you.

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Bottom line

Buying bonds can be a great way to diversify your portfolio and create a cushion to protect against market volatility. But just because bonds are considered generally safe investments doesn’t mean these come without risk. If you’re buying individual bonds, check the bond’s credit rating and evaluate the bond issuer. It’s typically easier, especially for beginners, to invest in bond funds. But these require your due diligence too. Luckily, the top online brokers offer various research tools and educational material to help you find the bond investments that are right for you.

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