In this article, we will cover details that you need to know before you jump into the bond market.
How to Invest in Bonds
Jumping into the market can be overwhelming when you’re getting started. There are so many different asset classes and you’ve got to figure out where you fit in the realm of investing.
Bonds are a top choice for fixed income products, or perhaps even a conservative investment approach.
Most people invest in bonds for an income stream, but there are other times they might fit into your portfolio. If you’re considering investing in bonds, take a look at this simple guide to walk you through how to invest in bonds.
We will cover details that you need to know before you jump into the bond market, and walk you through just what to do.
What is a Bond?
A bond is an investment interest that is tied to debt. Much like you might have a mortgage or a car loan, there are cities, municipalities, and tons of companies out there that need financial assistance for huge projects.
In the bond world, they will use a qualified lender with a specified interest rate for a certain number of years. You are not the lender when you purchase a bond. However, you are taking on a share of that debt by promising to hold the bond until a maturity date. In return, you get interest payments made to you on a regular basis.
The specific details of each bond are going to vary, but this is the basic concept.
Every bond is rated based on the risk of the bond. This rating may be helpful to you to choose a bond for your portfolio. You should also know that there are bond funds, which are just mutual funds or ETFs that hold bonds inside of them.
Different Types of Bonds
There are several different types of bonds to choose from. There are three primary categories, and that doesn’t include bond funds. For the purpose of keeping it simple, if we use the term bond, we are referring to a true bond. When using the bond fund verbiage, we will always differentiate by saying “bond fund”.
These are the three types of bonds.
- Corporate bonds
- Municipal Bonds
- Treasury Bonds
These bonds all work the same way, they just have different types of debtors. They also might have different benefits to you in some ways so let’s take a closer look at them.
As the name suggests, corporate bonds are for corporations and companies out there that need some capital. Most of the time these bonds are used for expansion, research and development, or an otherwise hefty expense that is outside of their normal expenditures.
Corporate bonds tend to be higher yielding bonds than other choices out there, but they also tend to have slightly higher risk too. When you earn interest from a corporate bond, this income is taxable. The tax liability to you will depend on your situation.
In the UK, you can purchase gilts, which are corporate bonds to UK companies and issued by UK banks.
Municipal bonds are issues on behalf of municipalities such as cities, states, and local governments. Much like corporate bonds, they are issued for a purpose. It may be for roads and highways, big public projects, or even public services available in that area.
Municipal bonds can cover a wide variety of things, but the key factor is that they are all through the municipal entities like we just described. Bridges, parks, etc. can all fall under this category. It’s often how those are funded.
When you earn interest from this type of bond, it is typically tax-free completely in most cases, but not all. They are federal tax exempt and depending on the bond may also be exempt from state and local taxes too. You’re helping out a major entity so this is the kickback for doing so. The interest you can earn is typically mid-range for a municipality.
There are also two different types of municipal bonds. They could include revenue bonds or general obligation bonds. General obligation bonds are backed by the municipality and any number of things can be done to ensure payments are made. That might even include raising local taxes to cover it.
Revenue bonds are paid back by any income derived from the project. A great example might be a toll road. They use a revenue bond to create the road and then maintain the road. They pay back the bond by generating revenue from tolls.
Finally, we have treasury bonds. These are often called T-bonds, and they are solely issued and paid by the US Government. They typically pay the lowest interest rate of all, but it just depends.
These bonds are backed by the US government for payment, and therefore considered to have zero risk to them. People often trade the reduction of risk for the lower interest rate in that capacity.
These bonds are usually exempt from your state or local taxes but could incur a federal tax liability. The bonds fund different project or financial needs for the US government.
Additional Ways to Invest in Bonds
Now, let’s talk about those other ways to invest in bonds.
This could include the following.
- Bond funds or ETFs
- Junk bonds
Bond Funds or ETFs
If you are struggling to narrow down the extensive list of bonds to choose from, that’s ok. Instead of trying to search for the single perfect bond, you might want to consider a bond fund or an ETF. These are similar, but ETFs are traded on the exchange, whereas mutual funds are not.
Both bond funds and ETFs will hold a wide variety of bonds inside of them. There are plenty of different bond funds out there and they come with a wide variety of differences and holdings.
You may have to do a little bit of research to find the top funds or what you feel will be the right fit.
These funds may have corporate, municipal, and treasury bonds all wrapped up in a nice little package. This package might even include some junk bonds to help push for higher interest without making it really risky.
The nice thing about bond funds and ETFs is that they are managed by trained professionals that do the research and make the picks. You may have to pay come fund fees or commissions, but you don’t have to worry about the management or selection piece.
The other way to invest in bonds is to buy junk bonds. What is that? Well, it’s a bond that pays much higher interest but it isn’t as highly-rated as other bonds out there. The rating is based on the likelihood of default. This means that junk bonds are more risky and more likely to default.
This type of bond won’t be for everyone, particularly if you are looking for a reliable income stream from bond interest. You could get lucky or you could take a huge risk.
How Do Bonds Work?
Let’s go just a little bit deeper here to better understand exactly how bonds work. When you purchase or even look at a bond, there are some terms to be familiar with.
When a bond first gets released, it goes only to the primary market and is available to a select group of people in some cases. It’s much like an IPO, or initial public offering. You might have access to it, but you might not. After that period has passed, the bonds are traded on the secondary market, much like stocks and mutual funds are.
Be familiar with these terms and how they relate to bonds.
- Risk: Risk is based on the bond rating. The highest rating a bond can receive is AAA, which means very low risk. Different agencies have different rating standards.
- Maturity Date: Every bond is assigned a maturity date. When you buy a bond, you are expected to hold until that date. Otherwise, you may lose some of your investment. This may be long-term or short-term.
- Issuer: a bond issuer is the entity that is managing the sale of the bond. They purchase this bond and are ultimately funding the cause with it.
- Coupon: a bond coupon is the stated interest rate. You might also see the term nominal yield. This refers to the interest that will be paid to you as a bond holder.
- Par Value: the par value is the face value of the bond. When the bond matures, you should get this value back.
- Market Value: this is the current value of said bond in the market. If the market price is lower than face value, you are purchasing the bond at a discount. If it’s higher, you’re purchasing the bond at a premium.
When you purchase a bond, you should have a face value of the bond plus the maturity date, coupon, and other pertinent details provided to you.
You choose the bond, pay the premium or discount to purchase it, and then you hold it until maturity.
As time passes, you will receive interest payments on a scheduled basis. Most bonds are set up to be semi-annual, but some are only annual and others might be quarterly.
How to Invest in Bonds Step by Step
If you’re ready to invest in bonds, it’s simple to do so. Remember that you might need to do some basic research in order to find the bond that is best for you. You can also just get right to it.
Here are a few simple steps.
- Login to your trading platform of choice. If you don’t have an account you will have to set one up. If you have a financial adviser, you could also work with them.
- Decide whether you want a bond or would prefer bond funds to invest in.
- Start searching through your options to find the best fit for you.
- Purchase the bond, paying the market value.
- Hold the bond and receive interest accordingly. Upon maturity, you will receive your investment back as long as the bond does not fail.
The steps are easy. The hardest part will be finding the right bond or bond fund for your needs. There are a lot of both on the market to choose from.
The Pros of Investing in Bonds
As with any type of investment, there are some pros and cons to dealing with bonds. Let’s talk about the pros first.
Bonds are famous for a steady income stream. As long as the borrower does not default on their loans, you will continue to receive interest payments per your agreement. It’s very similar to a bank CD in this way, except it’s tied to debt somewhere.
That income stream could be variable, but in most cases, it will be a fixed amount for the life of the bond until maturity. When it reaches maturity, you can then purchase a new bond or move to some other investment.
Your initial investment is the face value of this bond.
When maturity of the bond occurs, you receive this amount back to you, along with the final interest payment. That’s your trigger to turn around and purchase a new bond if you want to. But you get your capital back, and that’s the main point.
You can choose from bonds that are considered low risk to bonds that are considered guaranteed, which would be the government bonds. It’s ultimately up to you, but you have plenty of choices.
It is possible to purchase bonds at a discount, which means you are paying less than the bond is really worth. It can be a great deal
The Cons of Investing in Bonds
On the other side of the bond, there are some cons to be aware of too.
For example, purchasing a bond locks you into a maturity date. This means the funds are tied up and not liquid for the time being. If you need that cash, you can redeem the bond, but you’re probably going to lose some money in doing so. Be prepared to stick it out until maturity.
There is always the risk of default.
Even with government bonds, it’s possible a default will occur, although to date it never has. This is why checking out the ratings is important, as this is a default likelihood scale. Junk bonds have much higher risks.
You are putting yourself at risk for missing out on positive market movement. While you’re locked into a low-paying bond, the market could change. At that time, bond interest rates could skyrocket and you might miss out. This is just a risk of being in the market. This same knowledge ties to purchasing power and inflation exposure as well.
Bonds can be a great investment. Even if you are not solely seeking income in your portfolio, you can add some bonds or bond funds to create diversification as well. When you invest in a bond, your funds are supporting the goals of some business or government somewhere, but it’s up to you to choose the bond that works.
There are many different types of bonds, as well as bond funds. Know the risks and choose a bond or fund that fits your investment needs.
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