How to Invest in Bonds: A Beginner’s Guide
If you want to learn how to invest in bonds, then read on! Bonds are an essential part of a well-managed long-term portfolio. They are somewhat safer than buying stocks and one option for riding out volatility when the stock market gets rough, although the bond market does not always outperform stocks when times get tough. Read this guide if you want to know about investing in municipal bonds, corporate bonds, or federal government bonds.
In this Guide:
What are Bonds?
Bonds are a form of debt in which investors lend money to a company or government, and they often come in $1,000 or $10,000 increments.
Bonds are an essential part of the economy and a popular method for businesses and governments to raise funds—the proceeds from bond issues fund factories, roads, schools, and government operations. Bonds reach into most parts of finance, including banking and real estate.
Where Can You Invest in Bonds?
Some brokerage accounts allow you to buy bonds directly. However, this may not be the most efficient way for individuals to invest. It usually makes sense to buy bonds through a fund. Here are a few options if you're wondering how to invest in bonds.
1. ETFs and Mutual Funds Bonds
If you don't want to buy individual bonds, you're in luck. The best way to buy bonds is often through a mutual fund or exchange-traded fund (ETF). Many brokerages now offer free ETF trades, as this may be the most cost-effective way to invest in a diversified bond portfolio. Here are our recommended brokers to use:
| Highlights |  |  |  |
|---|---|---|---|
| Rating | 9.5/10 | 9.5/10 | 9/10 |
| Min. Investment | $0 | $0 | $0 |
| Stock Trades | $0/trade | $0/trade | $0/trade |
| Options Trades | $0/trade + $0.65/contract ($0.50/contract for 30+ trades/quarter) | $0.50/contract | $0.65/contract |
| Mutual Funds | |||
| Virtual Trading | |||
If you buy fixed-income funds (fixed-income is a term often used for bonds) or any other type of ETF or mutual fund, pay attention to the fees the fund charges. These fees could silently eat away at your earnings without you realizing it.
Bond funds come in a range of varieties. Some general investment funds, such as target-date funds, can hold a combination of stocks and bonds.
2. Investing in U.S. Government Bonds
U.S. government bonds are the closest thing you'll find to a risk-free investment.
However, there's a trade-off: Because they're considered very safe, U.S. government bonds pay among the lowest interest rates of any type of investment.
Government bonds come in many forms. You may have savings bonds stashed away from a gift when you were a kid. This is a type of government bond. But with bigger dollars, more types of government bonds are available.
Examples of types of U.S. government bonds include:
- Savings Bonds: Most savings bonds held for 20 years mature to their face value, double what was paid for them.
- Treasury Notes: Treasury Notes mature after two to 10 years, with a face value of $1,000 or $5,000.
- Treasury Bonds: Also called T-bonds, U.S. Treasury bonds mature after 10 to 30 years. They come with a $1,000 face value and pay a coupon (interest payment) twice per year. They're a significant part of U.S. monetary policy.
- Treasury Inflation-Protected Securities (TIPS): These bonds give investors inflation protection in their bond portfolios by floating with current interest rates.
3. Investing in Corporate Bonds
Corporate bonds are one of the two most common ways for big businesses to raise money. (The other is issuing new stock.) But unlike stock, managers don't have to give up a stake of ownership in the company when they issue bonds. Instead, bonds are a tool that raises money that has to be paid back.
Interest rates on corporate bonds vary based on the underlying company's credit rating. Standard & Poor's (S&P), Moody's, and Fitch are the three big credit rating agencies for bonds. BBB and above signifies “investment grade” on both S&P's and Fitch's scales. Ratings below that threshold are called “junk bonds” and carry higher interest rates for the higher risk.
Corporate bonds are much riskier than government bonds. If something goes wrong at the federal government, it controls the money supply and can ultimately pay off any U.S. debt. But companies can go bankrupt and miss payments. For example, Sears bonds dropped significantly in value when the company went bankrupt in 2018. Some bonds may be canceled or reduced in value during bankruptcy. So you should always take care when choosing where you invest.
Most corporate bonds are a $1,000 IOU. Some pay interest throughout the life of the bond, while others pay it back with the principal in a lump payment at the end.
4. Investing in Municipal Bonds
Municipal bonds, or muni bonds, are a type of bond issued by states, cities, counties and other government entities as a form of fundraising. Muni bonds have one very popular feature: They're often tax-free. That means you can earn income without paying income tax on your investment profit.
Municipal bonds may be somewhat low risk, but they're not the same as U.S. government bonds. Unlike the federal government, cities and local governments do go bankrupt from time to time. Detroit, Stockton, Calif., and San Bernardino, Calif., have gone through bankruptcies, as has Boise County, Idaho. In those cases, municipal bondholders were at risk.
As with all other investments, you should research and understand the risks and expected returns before investing in municipal bonds.
Should You Invest in Bonds?
You should always have some type of bond in your portfolio. If you are closer to retirement, you might want to invest more in government bonds than say the stock market, as you have a set rate return, and it is less impacted by the day-to-day volatility of the stock market.
Government bonds can be a good investment when interest rates are low because they have an inverse relationship. That means when the Federal Reserve lowers rates, the price of bonds rises, and vice versa.
It might seem counterintuitive, but this is because bonds usually have a lower rate of return than other investments. So when the Fed decides to lower interest rates, the fixed bond rate is more attractive to investors. If the Fed raises rates, the opposite happens. Bonds become cheap because fewer people find them attractive.
However, when interest rates are as low as they are today, it can be better to have less of your portfolio in Treasury bonds than other assets, depending on your situation. That's because today, bonds yield next to zero. We don't need to tell you that a near-zero yield is not enough to retire on. A decade ago, this yield was hovering around 3.5% for 10-year Treasuries, and 20 years ago, they were yielding 6%.
This means that over a long period of time (and the Federal Reserve has already hinted that zero rates are here to stay), the portion of your portfolio in bond would essentially act as a drag on the rest of your assets, such as stocks. It's like running a race but putting one of your legs in a cast for the fun of it.
The Impact of Inflation on Bonds
This isn't even taking into account inflation. Especially when you consider that the Federal Reserve has printed more money in the last 12 years than in the previous 95 (since its creation), combine that balance sheet expansion with one of the largest waves of fiscal stimulus in years, and you have a dangerous recipe for an uptick in inflation.
Simple: If your bonds are paying you 0.5% and inflation is 2%, then you haven't made 0.5%. Instead, you essentially lost 1.5% of your bond money's value. In an inflationary environment, 40% of your portfolio isn't just a drag on performance. Your bonds will be consistently losing money.
Those already invested in bonds should keep in mind that bond prices and bond yields are inversely correlated: when one moves up, the other moves down.
Bond yields are at historical lows and technically can't move lower without moving into negative territory. You can reasonably assume that we have hit bottom for interest rates. It's more likely over the long term that rates rise rather than lower. And higher interest rates means a decline in bond value.
That's not to say that bonds are useless. They certainly hold a place in a well-diversified portfolio, especially as a protection against a financial crisis. But overall, having a large hold in bonds doesn't make as much sense as it used to.
Bonds Can Have a Place in Your Portfolio
Still, if you have a diverse retirement portfolio, you could own bonds and not even know it! Look at your 401(k), IRA, or other retirement accounts to find out exactly what you have in them. If you manage things well, bonds should be a part of your long-term financial plan. Just remember that depending on the overall economic situation, they might not always yield as much as you would like.
