When you’re ready to take your savings to the next level and invest it, you’ve got options. There are mutual funds, stocks and other securities, but these types of investments can be daunting to new investors and returns can fluctuate wildly. Instead, consider investing in bonds, where your money will be kept out of reach while it grows at a steady rate.
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A bond is a low-risk investment where you’re lending money to either the government or a company at a fixed interest rate for a predetermined period of time. You’ll receive interest payments on your investment on a regular basis, with the principal amount paid back to you at the end of the term. Before deciding to invest in bonds, you should carefully compare your options, as some will pose more risk than others.
Case study: How do bonds work?
Edith has been transferring her spare cash into her savings account for the last two years, but is now starting to seriously think about her retirement. She decided to invest in a treasury bond, which will pay her interest twice a year on the investment. This is a low-risk option for her savings that will pay her the full investment back in 30 years when she’s closer to retirement.
By choosing a government-issued bond for her savings, Edith is able to diversify her investment portfolio while keeping a percentage of her money in her savings account where she can still add to the balance, earn interest and withdraw those funds as needed. The interest earned on her government bond will be added to this account, where it will then earn more interest.
Types of bonds
You have a few different options when investing in bonds. Each choice has its own risk and return potential, making it important that you compare your options carefully before deciding on any one product:
There are different types of government bonds, such as treasury bonds and municipal bonds, which are used to generate money for cash flow, financing debt, funding capital investments and more. These bonds are issued by the government so they are extremely low-risk, but often have lower interest rates than other options.
These types of bonds are issued by the federal government through the US Department of the Treasury.
US Treasury Bills. Short-term securities that mature within 52 weeks.
US Treasury Notes. Long-term securities that mature within ten years of being issued.
US Treasury Bonds. Even longer-term securities that mature within 30 years and pay interest every six months.
Treasury Inflation-Protected Securities (TIPS). Notes and bonds whose principal is adjusted for inflation according to the Consumer Price Index. They are issued for terms of five, ten and 30 years and pay interest every six months.
Municipal bonds are issued by states, cities, counties and local governments. While all of these bonds are used to finance capital expenditures, the specific purpose and repayment plan will vary depending on the type of bond that is issued:
Revenue bonds. Often used to fund public projects like water treatment plants or toll roads, revenue bonds are repaid by the revenue generated from the project.
General obligation bonds. These bonds are not backed by revenue from a specific project and are repaid through general taxation and municipal revenue or funds.
Conduit bonds. These bonds are issued on behalf of private companies like non-profit colleges or hospitals and backed by the third party as opposed to the government.
This type of bond is usually a part of a public offer, where a company will issue a prospectus that informs consumers about the offering and allows them to make a direct investment. This is different from buying shares, where you are a part owner and your investment affected by the cash flow of the business. With corporate bonds, you are a creditor and your return is limited only to the agreed-upon interest payments and the return of your principal investment. They usually have a higher investment rate than government bonds but are also riskier — if the company fails, they may default on the debt.
Investment-grade bonds. These bonds have a high credit rating (BBB- or higher), which suggests that the company is in a relatively strong financial position and has the ability to repay the bonds.
High-yield bonds (junk bonds). These bonds have a lower credit rating (BB or lower) than investment-grade bonds. However, they generally pay higher interest rates in exchange for the increased risk.
Convertible bonds. Most often issued by companies with low credit ratings and high growth potential, these bonds can be converted to a predetermined amount of common stock or cash.
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. Bonds are typically less volatile than other types of investments, such as shares, but it’s still possible to lose money with government-issued bonds. Bonds 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.
Pros and cons of bonds
Like any investment, bonds have their own set of pros and cons:
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
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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
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 bonds will drop as a result. These fluctuations are only relevant if you’ve invested in floating rate bonds as opposed to fixed-rate bonds 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 with bonds, you’ll first need to decide which type of bond is right for your financial strategy:
Type of bond
Finance US government debt, capital expenditures, etc.
Cities, states, counties
Finance municipal purchases and public projects
Tax-exempt at federal level, exempt from state and local if issued by your home state.
Finance growth, debt, capital expenditures, research
Taxable at federal, state and local levels
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.
How to buy bonds
Now that you’ve decided which type of bond you’d like to buy, there are a few ways to make an initial purchase.
If you’re looking to buy new-issue bonds, you can purchase them on the primary market, which is usually directly from the issuer.
You can purchase US Treasury Bonds directly from the government on a website called TreasuryDirect, which allows you to avoid transaction fees from brokers. You can also purchase up to $5,000 (in $50 increments) of Series I paper bonds with your tax return.
Municipal bonds are generally offered for a short period of time through a single bank or group of banks. A prospectus or offering document would be issued, highlighting the different maturities and yields. During the offering period, you would put in a request to purchase with the investment representative at the specified bank.
New-issue corporate bonds are not usually available to the public, as most of them are sold to large institutions and banks which sell them in the secondary market. While unlikely, you may be able to purchase them directly from the underwriting investment bank in an initial bond offering.
The secondary market is where you’ll find investors and other institutions looking to resell existing bonds. This is done through brokers, which are a third party that allow you to purchase bonds from another entity on your own or with the help of an investment representative. You’ll specify which bonds you’d like to purchase and the broker will search for another person selling them, then purchase them for you, often with a markup to cover commission.
Brokers can also help you resell bonds before they reach maturity. Once you’ve purchased a bond, you can choose to hold it until maturity or sell it on the secondary market. You’re not required to pick one or the other, so there’s nothing stopping you from collecting interest then reselling the bond if its value increases.
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Bonds can be a prudent way to keep your money safe over a long period of time and are a great way to diversify your portfolio. Splitting your savings between a traditional savings account and a government or corporate bond can help you earn interest on your money without taking on too much risk. Assess your financial situation and compare your investing options to determine whether buying a bond is right for you.
Peter Carleton is a writer that covers banking and investing, breaking down what you need to know about where you put your money. When Peter's not thinking about cutting-edge banking apps and robo-advisors, he runs a creative agency and spends his spare time cooking or reading.
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