It can be scary being an investor. The volatility of the stock market can make you jittery, especially if you are new to the market. However, stocks aren’t the only option available if you’re looking to invest your money and hopefully see it multiply over the years.
You can consider investing in bonds. It is one of the safest ways for investors to start building their portfolio.
What is a Bond?
Bonds are financial securities issued by both the public and the private sector. When you buy a bond, you are essentially loaning the bond issuer a given amount of money for a fixed period. The issuer, on the other hands, commits to making regular interest payments at a preset rate until the bond matures.
After maturity, you can redeem your entire principal. Investing in bonds can be a profitable venture if you know how to do it. Otherwise, you may end up regretting the risk you took. It’s also worth noting that there are two ways to make money from bond investments:
- You can hold the bond until maturity and collect regular interest payments
- You can buy bonds at a certain price and then sell them for a price higher than the initial buying price.
Types of Bonds
There are several different types of bonds. Let’s explore the three main forms:
- Treasury bonds – Also known as T-bonds, treasury bonds are issued by the U.S. government. They mature in at least 10 T-bonds are considered almost risk-free as they are supported by the full faith and credit of the U.S. government. The interest you earn from these types of bonds is taxable by the IRS, but it’s non-taxable at the state and local level.
- Corporate bonds – These types of bonds are issued by companies to raise finances for business-related projects such as product development, business expansion, and research. The interest you receive from corporate bonds is taxable at both the federal and state level. A major advantage of these types of bonds is that they normally offer higher interests compared to other types of bonds.
- Municipal bonds – These bonds are issued by local authorities, such as a state or a city, to finance public projects or deliver public services. There are two types of municipal bonds – general obligation bonds and revenue bonds.
While general obligation bonds are backed by the issuer, such as a city, revenue bonds are backed by the income streams to which the bonds are tied.
The interest you receive from both types of bonds is non-taxable by the IRS and the home state. Municipals bonds normally offer lower interest rates than corporate bonds.
While bonds are normally said to be a safer investment than stocks, investing in the wrong bonds could expose you to unnecessary risks. Hence, it’s advisable to evaluate a bond before you take the plunge. So, here are a few important things you should look for in a corporate or municipal bond that you want to invest in:
The most important factor to look out for is whether the issuer can actually pay its bonds. You can determine this by looking at the issuer’s credit ratings.
The higher the rating, the lower the chances of your issuer defaulting on its obligations. Credit ratings are normally issued by rating agencies such as Standard and Poor’s, Moody’s, and Flitch.
It’s also worth noting that the more risk you take, the higher your reward will be. That means you’ll bag a higher interest rate if you purchase bonds from an issuer with a poor rating.
This is the period, expressed in years, it will take you to recover the true price of a bond, taking into account the current value of its future interest payments and principal repayment.
A bond’s duration helps to determine the sensitivity of a bond to interest rate changes. The longer the duration, the greater the fluctuation in case of a change in interest rates. Note that a rise in interest rates leads to a drop in the value of a bond.
The best way to ensure that you get your predetermined interest rate and your entire principle is to hold on to your bond until it matures.
If you aren’t purchasing directly from the underwriter, it’s important to consider the fees that a brokerage can add to the cost of a bond. You can review the publicly available data on the pricing of the bond you are planning to buy to ensure you are not being fleeced.
You can also get a wealth of information about the pricing of bonds on FINRA’s (Financial Industry Regulatory Authority) website.
How to Buy Bonds
There are two major ways to purchase bonds. Review them below to choose one that works well for you:
From a Broker
You can buy corporate bonds, treasury bonds, or municipal bonds from online brokerages. There’s a wide selection of brokers out there, from which you can buy your bonds.
It’s worth noting, however, that bond prices vary from broker to broker. This can be attributed to transaction fees as well as markups or markdowns.
It’s important to do your research to find a broker that offers a fairer deal for the bond you’re interested in purchasing.
Through the U.S. Treasury Department
You don’t have to go through a broker to purchase new Treasury bonds. You can buy them directly from the U.S. government. The best thing about this approach is that the Treasury doesn’t collect fees or mark up the bond’s price.
You should realize that bonds play a great role in controlling the market’s money supply. Therefore, investing in bonds when the economy is facing a cash crunch is not a good idea. During such a period, investors would normally be selling out their bonds to meet their own money demand.
The result of this will be an oversupply of bonds in the market, resulting in a drop of bond price. Consequently, you’ll lose on your investment.
If you don’t want to bear the risk of purchasing an individual bond, you can consider investing in bond funds.
Let’s take a quick look at what bond funds are.
Bond funds, also referred to debt funds, are very similar to individual bonds. However, your portfolio is professionally managed.
A bond fund acts like a mutual fund that invests exclusively on bonds. Many investors consider it a more efficient way of investing in bonds compared to purchasing individual bonds.
You might be wondering how bond funds work. A bond fund manager or a team of managers carry out an in-depth research of the fixed income markets for the best bonds, taking into consideration the general objective of the bond mutual fund. Afterward, the managers will buy and sell the bonds based on how the economy and the market performs.
Moreover, bond fund managers have to sell funds to meet investors’ withdrawals. Besides mutual funds, certain Exchange Traded Funds (ETFs) also invest in bonds. ETFs trade your bonds like stock shares.
With an ETF, you should realize that you’re purchasing your bonds from other investors and not directly from the issuers.
The biggest disadvantage of mutual bond funds and ETFs is that they normally don’t have a maturity day. This is attributed to the fact that your portfolio is constantly changing as you often add and eliminate bonds.
So, if you are looking to hold your bond until maturity, bonds funds are not a good investment for you. Another disadvantage of this kind of investment is that you will incur additional costs for paying the portfolio managers.
Alternative Investments to Bonds
Pros and Cons of Investing in Bonds
- Fixed investment returns – You receive a fixed interest rate plus your principal upon the maturity of the bond
- You’re exposed to lower risks than when you invest in stocks
- Less volatile compared to stocks – While a bond’s value can fluctuate due to market dynamics, they’re normally more stable than stocks
- Can be rated by credit rating agencies, making it easy to evaluate various bonds before investing in them
- Some bonds require huge sums for investment, which may lock out many investors
- Less liquid than stocks, especially those bonds issued by smaller, less financially stable companies
- Bondholders are highly exposed to interest rate risk
Are You Ready to Invest in Bonds?
Investing in bonds can be a profitable venture, with minimal risks, but you have to learn how to do it properly.
If you invest in bonds without paying attention to important factors like evaluating a bond before investing and researching to ensure you’re getting a fair deal from a brokerage, you may live to regret the risk you took.
If you don’t wish to shoulder the risks that come with bond investment, you can opt for bond funds where your portfolio is professionally managed.
This gives you peace of mind as you’re protected from risks. But keep in mind that bond funds don’t have a maturity period.