Investment conversations typically focus on the stock market, but any financial adviser will tell you a portfolio is strongest when it’s diversified. That means you don’t want to only invest in stocks. A balanced portfolio contains bonds as well.
Bonds are inherently low-risk investment options, but they also don’t have the high potential earnings of stocks. Instead, buying bonds provides a hedge against riskier stocks.
Understanding when and how to invest in bonds is an important piece of your investment strategy.
When you need to buy something you don’t have all the money for, you take out a loan. When corporations and governments need to take out loans to raise money for a specific endeavor, they issue bonds.
They promise to pay back lenders (that’s you!) in a set number of years at the bond’s maturity date, or when the bond ends. A corporation or government can issue bonds for things like funding research for a new product to raising money to build new infrastructure.
The bond issuer also makes interest payments along the way, typically twice a year. These are known as coupon payments.
One exception: zero-coupon bonds, which don’t pay interest until the maturity date. Some people choose them as investments for their children with the idea that the bond will mature when it’s time to pay for college tuition.
3 Types of Bonds Explained
There are three main types of bonds to know about as a beginning investor in the bond market: treasury bonds, municipal bonds and corporate bonds.
Also called T-bonds, Treasury bonds are issued by Uncle Sam. They are entirely backed by the federal government, and they’re issued at maturities of 10 to 30 years. The interest you earn is tax-free at the state and local levels, but you’ll still pay federal taxes on it.
The biggest draw of a treasury bond? It’s essentially risk-free unless the U.S. government goes under. And if that happens, we probably have bigger things to worry about.
Treasury bonds typically yield similar interest rates as comparable municipal bonds.
Municipal bonds, also called “munis,” are issued by cities, states and other local governments to fund projects like building roads or renovating parks.
Interest on a municipal bond is exempt from federal taxes. When you purchase a municipal bond in your own state, the interest is often exempt from state and local taxes, as well. An added win: As a citizen, you enjoy the rewards of your investment by using the services of your city and state every day.
There are two types of municipal bonds:
General obligation bonds, which are used to fund public works. These bonds are backed by the full faith, credit and taxing power of the issuer. That means that, if necessary, the issuer will raise taxes to repay bondholders.
Revenue bonds are backed by a specific project, like a hospital, toll road or stadium. They aren’t backed by the full faith and credit of the issuer, which makes them riskier. They pay higher interest rates than general obligation bonds because of the higher risk.
Corporate bonds are the riskiest of the three types of bonds.
Unlike the previous two categories of bonds, these bonds are issued by companies. Purchasing a bond from a company is different from purchasing stock, which gives you partial ownership in that company, whereas with a corporate bond, you’re lending a company funds.
They come with credit risk, which means that if the corporation can’t afford to make its debt payments, bondholders may not get their interest and principal payments. If the corporation files for bankruptcy, secured creditors get paid in full before bondholders recoup their bond investments.
The biggest draw of a corporate bond is that it will typically pay out the highest interest rate of the three main categories of bonds.
4 Benefits of Investing in Bonds
Investing in bonds has several key benefits:
1. They Are Generally Safe Investments
All investing involves risk at some level. There’s virtually no risk of default with Treasury bonds, but because the risk is low, so are the interest payments. You run the risk that they won’t keep up with inflation. You could also miss out on other investment opportunities that yield better returns. But if you’ve got slim to no risk tolerance, these bonds may be up your alley.
It is very unlikely that the issuer of a municipal or high-quality, investment grade corporate bond will default — but if they do, you lose out on that investment. (Default is a greater possibility with junk bonds, which are the riskiest corporate bonds. They pay a high yield to compensate investors for their increased risk.)
Because the stock market can be so volatile, fixed income investments like bonds can balance out the high risk of stocks. This is especially important as investors near retirement age and can’t afford as much risk. Many financial planners recommend that investors gradually shift more of their portfolio from stocks to bonds as they get older.
2. They Provide Fixed Income
Bonds offer some regularity to your income stream, because you can typically count on the coupon payments twice a year. Because bonds offer fixed income, they’re a popular investment choice for retirees. In fact, another term for bond is fixed income security.
This is a stark difference from stocks, which are much more volatile and thus cannot be relied on for fixed income.
3. They Give You the Chance to Give Back
Municipal bonds in particular are appealing because they give you a sense of improving your own community. The same can be said of Treasury bonds, just on a larger scale.
Even corporate bonds can instill a sense of investing purpose if you are passionate about a specific product or brand for which the company is trying to raise money.
4. They’re Easy to Manage
If you don’t use a financial adviser, playing the stock market can be tough. When do you buy? When do you sell? And how do you do those things?
With bonds, you can earn income just by buying once and letting the bonds mature — although some investors do sell their bonds before the maturity date at a profit or loss.
3 Drawbacks to Investing in Bonds
Bonds are not without drawbacks. Here are a few:
1. Most Bonds Aren’t High Earners for Your Portfolio
Bonds provide stability in a diversified portfolio, can be a reliable income source and balance out high-risk stocks. However, the lower the risk, the lower the reward. Compared to stocks, bond growth is minimal.
Large stocks have had average annual returns of 10% since 1926, while large government bonds earned average annual returns of 5% to 6% over the same period, CNN Money reports.
Buying bonds, however, carries some risk, though it is small compared with that of stocks. A bond issuer could default on the bonds, meaning you might not earn interest, might lose your principal investment or both. This is known as credit risk.
Another type of risk with bonds is interest rate risk. When interest rates rise, bond prices — and thus the value of your bonds — decrease because investors can earn higher interest rates elsewhere. But there’s an upside to interest rate risk: When interest rates drop, bond prices go up, meaning your bonds could be easier to sell if they’re paying interest rates that are higher than the current market rate.
Inflation risk is another liability to consider: If the interest you’re earning from a bond doesn’t keep up with inflation, you’re essentially losing money because you’re losing buying power.
Finally, there is liquidity risk. Whenever your funds are tied up in assets, whether the stock market or the bond market, they are illiquid. If you need to sell your bonds to meet a financial obligation but can’t find a buyer, you might have to sell at a lower price and lose money.
3. Your Funds Are Tied up
When you purchase bonds, you generally need to be committed to investing for the long haul. With savings accounts, you can access your money when you need it, and stocks can be bought and traded as you see fit. Bonds, however, require you to wait until they mature to get the full rewards of the investment.
How to Invest in Bonds
Unlike stocks, which are traded on a public exchange, bonds must be purchased from brokers — unless you are interested in government bonds, which you buy from the United States directly.
How Are Bonds Rated?
A bond rating signifies to investors how strong a bond is and how likely the issuer is to pay back the principal with interest. But where do such bond ratings come from? Ratings agencies.
You can use bond ratings from Moody’s, Fitch and Standard & Poor’s to assess the strength of a bond. In general, you should concern yourself with a bond’s credit quality, maturity and yield.
At first glance, the rating system can be confusing. AAA to Aaa bonds are considered high-grade bonds that have a high chance of being paid (though they’ll also likely have a lower interest rate). BBB to Baa are also considered investment-grade bonds; they will not likely default.
When you get down to BB and Ba bonds,or junk bonds, you are taking on a little more risk since such bonds are subject to greater price volatility. Remember: Greater risk brings greater reward.
A bond rated as D is currently in default. Stay far away.
Individual Bonds vs. Bond Funds
How much money you can invest in bonds depends on several factors. Individual bonds issued by the U.S. Treasury, for example, are sold in $1,000 increments. Municipal and corporate individual bonds are usually sold at the $10,000 level or higher, sometimes even reaching $100,000.
Bond funds (bond mutual funds and bond exchange-traded funds) are alternatives to purchasing individual bonds. Bond mutual funds and bond ETFs represent a range of investments all poured into a single bucket. If one of the bonds defaults in that bond fund, you still have the other bonds to protect your investment. Diversification is the beauty of bond funds; financial advisors commonly use mutual funds (both bond funds and stock funds) to protect you against big risks.
You’ll have to go through a bond mutual fund company to purchase any bond mutual funds, but bond exchange-traded funds are traded on stock exchanges.
When you purchase individual bonds, you will need to thoroughly research the issuers before putting your faith in them.
If you are serious about investing for your future, bonds will play an important role — but not the leading role. To figure out the right balance of stocks and bonds for your investment portfolio, talking with a financial adviser is a good place to start.
How to Open a Brokerage Account
Unless you are investing in government bonds, you will need a brokerage account for buying bonds. You can work with a financial advisor to open and manage a brokerage account (and get helpful investment advice) or even utilize a robo-advisor, but you can also own a brokerage account without the help of a third party.
We highly recommend using a financial advisor or investment platform for managing a mutual fund or exchange-traded fund as part of a larger investment strategy, but more skilled investors may prefer to manage things themselves. Want to go it alone? Get our tips for opening a brokerage account in 4 easy steps.
Frequently Asked Questions About Bonds
Are Bonds a Good Investment?
This depends on your goals and risk tolerance. Bonds are low risk, but their payoff is often not much better than the interest rate of a high-yield savings account, and the money is far less liquid. Bonds make more sense as part of a well thought-out, diversified investment strategy. As you enter retirement, bonds can be a reliable source of fixed income.
How Much Do I Need to Invest Directly in Bonds?
This depends on the type of bond. The U.S. Treasury sells individual bonds for as low as $1,000, and corporate and municipal bonds typically start higher. It’s much easier to build a bond portfolio by buying shares of a bond mutual fund.
Can I Invest Directly in Bonds?
You can purchase most bonds through a broker. If you are new to bond investing, we highly recommend working with a financial advisor.
Treasure bonds are the exception to the rule. You can buy most government bonds directly from the government.
What Is a Bond Ladder?
Bond ladders are an investment strategy that, over time, ensures that you always have bonds maturing and thus are always getting a nice chunk of cash paid out.
For example, if you have $200,000 to invest (in theory), you could invest $20,000 a year in 10-year bonds. At the end of the 10th year, the first bond will mature and pay out. You can pocket that payoff, reinvest the initial $20,000, and wait for the next bond to mature the following year. At that point, you will have an endless source of income with bonds maturing every year.
Timothy Moore is a market research editor and freelance writer covering topics on personal finance, careers, education, travel, pet care and the automotive industry. His work has been featured on Debt.com, Ladders, Glassdoor and The News Wheel.
This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.