There’s a time and a place for everything, and that saying couldn’t be more true than when purchasing bonds. Traditionally, bonds seem as if they’re low-risk and therefore, also low-return. However, consider this on-the-cusp-of retirement scenario: If you’re 62 and ready to retire soon, you’ll likely not want your hard-earned retirement money invested in risky stocks. Bonds, in this situation, just might be the best way to go. However, that’s a generalization and it’s always best to carefully research your options to make sure bond investments are the best option for you.
What is a Bond?
Bonds are fixed-income securities which provide investors with fixed periodic payments and the eventual return of principal at the maturity of the security. In other words, a bond is an agreement signed between a bond issuer and investor, which specifies the fixed amount the bond issuer is obligated to pay the investor at specified intervals. A bond is a loan advanced by the bond purchaser to the bond issuer (can be a government, municipality or corporation) and is a debt instrument that functions like an IOU. However, it’s important to remember that bonds are not risk-free.
What is a Bond Fund?
Bond funds own hundreds (or thousands) of bonds and are a great way to invest in many bonds at once. Just like mutual funds, you pool your money with other investors and a money manager will invest your money for you. You’ll achieve diversification with this type of bond investment, compared to buying individual bonds.
Types of Bonds
A tutorial of how to purchase bonds isn’t complete without a rundown of a few types of bonds you can purchase, as the method for purchasing them will be different, depending on what type of bond you’re after. Common types of bonds include:
- Treasury bonds
- Corporate bonds
- Foreign bonds
- Mortgage-backed bonds
- Municipal bonds
- Other U.S. government bonds
Why Purchase Bonds?
Bonds can provide balance to any portfolio, especially if a portion of the portfolio contains high-risk stocks. Check out the chart from Merrill Edge, which shows the different types of asset allocations available in well-diversified portfolios. This type of portfolio diversification using bonds is very common among other brokerages. Check out the bond percentages for the different investor profiles, and you’ll see how bonds grow as a portfolio needs to become more conservative.
The percentage of bonds grows as a portfolio needs to become more conservative
Bonds also provide an income stream that is fairly predictable, as they usually pay investors interest two times a year. There’s also an option called a bond ladder, which can help build even more predictable income. See the chart from Fidelity, below, to understand bond ladders and how to stagger bond maturities, which can help with that income stream.
Capital preservation is another way in which bonds will work in your favor. If your main interest is to prevent loss in your portfolio, then bonds could be your ticket. Only safe, short-term instruments such as bonds can typically ensure that capital preservation and generate steady returns even in the face of a highly volatile investment environment.
Tax Advantages of Investing in Bonds
The interest on all series of U.S. savings bonds is fully taxable on your federal income tax return but is exempt from state and local tax. If you follow IRS rules, you can exclude portions of the interest earned on Series EE and Series I bonds purchased after 1989 from your income as long as you use that interest to pay for qualified higher education expenses. Municipal bonds, on the other hand, are exempt from federal taxes, and if you buy bonds issued in your state, you can avoid state and local taxes, too. This can be helpful if you’re a high-income earner who needs a way to reduce taxable income.
Ways to Purchase Bonds
Purchasing a bond is pretty straightforward, though not necessarily as easy as ponying up just small amounts of cash. A lot of bonds require a little bit of cash to purchase. You can buy bonds from TreasuryDirect, and the benefit to U.S. treasuries is that they’re backed by the full faith and credit of the U.S. government. They’re typically going to offer lower yields compared to other bonds because they’re low-risk. U.S. Treasury bonds also carry with them certain tax advantages as well as offer high liquidity to investors. You can also buy bonds from a broker/dealer, just like you’d purchase a stock or a mutual fund. For an in-depth look at how purchasing treasuries can work through a broker, check out some of their features on Fidelity’s website. The list includes various U.S. treasuries, including U.S. Treasury bills, notes, bonds, inflation-protected securities, zero-coupon bonds and STRIPS. For more information about Fidelity, read Benzinga’s comprehensive Fidelity Investments review. You can also purchase bonds from a bank or group of banks, or in the case of municipal bonds, directly from the municipality.
Risks to Know Before You Buy Bonds
As mentioned above, there are still risks involved when purchasing bonds.
- Interest rate volatility: If you need to sell a bond before its maturity date, you’ll lose money if interest rates are higher than when you bought it.
- Inflation risk: Since bond interest payments are fixed rather than at the mercy of the upticks in the stock market, bonds’ value can be eaten away by inflation. The longer the term of the bond, especially, the higher the inflation risk.
- Liquidity risk: If you use bonds in a speculative way, liquidity risk may apply. This means that you aren’t able to sell securities quickly at an attractive price, due to an imbalance of buyer and seller numbers or because of volatile prices.
- Credit or default risk: This simply means that a bond issuer will default on principal and interest payments. Typically, high-yield bonds are more susceptible to this type of risk.
- Ratings risks: Bonds are rated ranging from “AAA,” the highest grade, to “C” or “D,” which aren’t desirable at all. Ratings that are higher risk are determined by the major ratings agencies: Moody’s Standard and Poor’s and Fitch Ratings. A lower rating by any of these agencies must be considered when determining the best bonds for your portfolio.
What to do after Buying a Bond
After you buy a bond, it’s important that you monitor interest rates, as well as how the market is performing (and that goes for any investments you have). You’ll also need to be aware of the maturity date, or the date it must be repaid. During the term of the bond, a few things may happen. Interest rates may rise or fall. When interest rates rise, the value of bond funds drop. Though you might feel pressure to yank your bonds out, remember, you’ll still gather steady income from them. If interest rates go down, on the other hand, your bond value will go up.
Selling Prior to Maturity
Just like the overview above, if you sell a bond before it matures and interest rates have risen, you may have to sell below face value, or “par value.” If you sell above par, that typically means that interest rates have fallen. It’s likely that you’ll want to ask if you’ll need to pay a commission. If you’re considering selling before your bond matures, it’s a good idea to check with your broker to find out how much their “markdown,” or percentage of reduction in sales price.
Final Thoughts on Buying Bonds
When considering bonds or bond funds, it’s important to consider how long you plan to hold onto them. Consider your goals, your time horizon, risk tolerance and when you’ll need the money at the end. If your time horizon is one year, a short-term bond fund obviously makes the most sense, and if you don’t need the money for 10 years or more, go the long-term route.