What to Know Before You Invest in Bonds

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Bonds are a relatively low-risk way to invest your money, and many financial experts recommend using them to provide a hedge against the volatility and uncertainty of the stock market.

Before you invest, though, it's important to know how bonds work and how to use them in your investment strategy.

How Do Bonds Work?

Bonds are debt securities issued by government agencies and corporations that are looking to raise money. When you buy a bond, you're essentially loaning money to the issuer in exchange for full repayment on the date the bond matures and typically also recurring interest payments. For example, if you were to buy a $1,000 bond with a five-year maturity and a 5% interest rate, you might receive semi-annual payments of $25 for five years, then the full $1,000 at maturity.

After bonds are first issued, they can be traded like stocks. While the interest payments and face value (called par value) of the bond don't change, the current price can fluctuate based on supply and demand, how long until the bond matures, current market interest rates and the credit quality of the bond issuer.

Bonds from issuers with better credit ratings tend to offer lower interest rates because there's a higher chance that the issuer will pay off the debt. While issuers with lower credit ratings offer higher interest rates, there's a greater risk that you won't get all of your money back. In either case, bonds typically offer lower returns than stocks.

Here are some terms you may come across as you dive into the world of bonds:

  • Par value: Also known as the bond's face value, this is the value of the bond when it's first issued and the payment you'll receive from the issuer when it matures. Most bonds have a par value of $1,000.
  • Coupon rate: This is the interest rate that the bond pays. In most cases, it won't change after the bond has been issued. There are also zero-coupon bonds that don't pay any interest but sell at a deep discount so that you still profit when the bond matures.
  • Yield: A bond's yield refers to the return an investor receives from a bond based on its current price. For example, a 5% coupon rate on a bond currently worth $900 is more valuable than a 5% coupon rate on a bond worth $1,200. Divide the annual interest payment by the price of the bond to get the current yield.
  • Discount or premium: When a bond trades at a price that's lower than its par value, it's trading at a discount. When it trades at a price that's higher than the par value, it's trading at a premium.
  • Bid and ask price: Bonds are quoted on a bid and ask price. The bid price is the highest price buyers will pay for a bond, and the ask price is the lowest price offered by the seller.

When You Should Invest in Bonds

Bonds can provide a good safety net when other investments don't pan out, especially in the short term. However, it's also good to consider bonds in your long-term investment portfolio. Here are times to consider investing in bonds:

  • You want to generate income. While bonds don't provide the same returns as stocks, they can offer regular income payments, which can especially be helpful during retirement.
  • You need a more conservative portfolio. As you near retirement, it's more important to conserve the wealth you've accumulated than to maximize it. As a result, financial advisors typically recommend investing more in bonds than stocks leading up to retirement.
  • You want a little diversification. Even if your investment goal, such as a comfortable retirement, is decades away, it may still be a good idea to invest a small portion of your portfolio in bonds to provide some diversification. That way you're not relying completely on stocks.
  • You want tax benefits. Some government bonds provide tax benefits to their investors. For example, municipal bonds, which are issued by state and local governments, are shielded from federal taxes and often state taxes too. Also, Treasury bonds are subject to federal taxes but not state taxes.

When Not to Invest in Bonds

Although bonds can provide some excellent benefits to investors, there are still some risks associated with them:

  • You expect interest rates to rise. Bond prices have an inverse relationship with interest rates. When market rates for bonds increase, the price of an existing bond will go down because its lower coupon rate is less attractive to investors.
  • You need the money sooner than the maturity date. Bond maturities typically range from one to 30 years. If you buy a bond but need the money before it matures, you can always sell it on the secondary market, but you risk losing money if the price of the bond has decreased.
  • The risk of default can be high. As previously mentioned, you can get higher coupon rates from bonds with lower credit ratings—but unless you're willing to lose your initial investment, it might not be worth it. Take the time to learn about bond credit ratings so you can make an educated decision about where to invest your money.

All of this is not to say that you shouldn't invest in bonds. But make sure you understand the risks beforehand. There are also ways to avoid some of these risks through the way you buy your bonds.

How to Buy Bonds

Depending on your experience and goals, there are a few different ways you can buy bonds. Here's a quick summary of each.

Go Through a Broker

If you want to buy individual bonds from a government agency or corporation, you may be able to do so through a broker. Remember that par values are generally $1,000, and they can go up or down in the secondary market.

What's more, you can't purchase fractional shares with bonds as you can with stocks, so whether you want to buy a new-issue bond (from the issuer) or a bond on the secondary market (the stock market), you'll need to have enough cash in your account to buy whole bonds.

Buy Directly From the Issuer

It can be difficult to buy corporate bonds in a primary bond offering unless you have a relationship with the financial institution that's handling the offering. But with Treasury and municipal bonds, you can typically buy them directly from the government agency that's issuing them via auction or retail order.

Invest in a Fund

Bond mutual funds and exchange-traded funds (ETFs) provide a lot of the same benefits that you can get from buying individual bonds, but they also offer diversification. These funds often include hundreds of bonds, so you're not overly exposed to the risks associated with each individual one.

Plus, it can be easier to invest in a fund than to buy an individual bond. That said, these funds typically have fees to compensate the fund managers. ETF fees are generally lower than mutual fund fees.