What Is A Bond? How They Work And How To Buy For Beginners

What Is A Bond?

A bond is a fixed-income investment which represents a loan made by an investor to a borrower, for example a private company or local government. Bonds are considered fixed-income because the investor earns interest, or a coupon, from the borrower throughout a bond’s term.

Bonds are also considered a safe and more stable investment compared with equities, as their main goal is capital preservation and income generation. It should be noted that recent performance of TLT and other safe bonds as well as junk bonds in comparison has stirred some investors to question whether typically deemed “safe” bonds are actually safe. In short, some bonds, like junk bonds, trade a higher coupon for higher risk of default, but are safer from changing rates. Meanwhile, Treasury bonds are safer from default.

How Do Bonds Work?

Bonds are simple to understand when you consider that they’re just a vehicle for lending money to an entity like a company or government in exchange for interest payments on a set schedule over an agreed-upon term. When investing in bonds, there are a few key terms and definitions you need to know:

While generally considered a safer investment than stocks, bond prices can still fluctuate based on factors like changes to credit ratings and interest rates, as well as a loss or gain of market demand. By understanding the above terms and definitions as well as the below descriptions of bond types, you can invest in the right bond type for your investment profile.

Types Of Bonds Beginners Should Know

There are four types of bonds you should know, each with their own risk profiles, coupons, tax implications and risks and rewards.

Government Bonds (U.S. Treasuries)

Government bonds, or U.S. Treasuries are issued by the U.S. Treasury Department to fund government expenses and are considered one of the safest bond options because they’re backed by the full faith and credit of the federal government. There are three main types of Treasuries differentiated by bond duration: Treasury bills which are short-term, Treasury notes which are intermediate-term and Treasury bonds which are long-term. During periods of market uncertainty, Government bonds are considered a safe haven for U.S. and international investors.

Municipal Bonds (Munis)

Municipal bonds are debt issued by states, cities and counties to fund public works like bridges and libraries and whose interest payments are often exempt from income taxes. Munis are most appealing to wealthy or retired investors seeking income which is tax-advantaged . Municipal bonds are generally either general obligation bonds, meaning they’re repaid by tax revenue, or revenue bonds, which means they’re repaid by a government project’s revenue like toll revenue.

Corporate Bonds

Corporate bonds are issued by companies to fund the firm’s operations, expansion into new or existing markets, or to refinance their previous debt. These bonds often pay a higher coupon than Treasuries or muni bonds but they also carry higher risk just as stocks often carry more risk. For the investor’s benefit, rating agencies like Moody’s rate corporate bonds based on the firm’s credit-worthiness.

Junk Bonds

Junk bonds are issued by companies who have lower credit ratings and are more likely to default on their debt than corporate bond issuers. In exchange for higher risk, high-yield bonds offer attractive coupons to investors. While you can earn more in yield from junk bonds, you should consider how much risk your portfolio can tolerate and whether you can lose all of your principal investment.

Bond Funds And ETFs

A bond fund and bond ETF isn’t a type of bond but is an actively or passively-managed investment vehicle which allows investors to invest in a portfolio of bonds. Bond funds and ETFs allow you to invest in a particular segment or diversified mix of bonds, for example, a bond fund could be an investment in a broad index of the bond market or could be targeted investing in just government bonds. These funds and ETFs are ideal for investors who are just getting started in investing and don’t want to select individual bonds or could be ideal for seasoned investors who want diversification or professional management of bond investments for their portfolio.

Benefits Of Investing In Bonds

There are five core benefits of investing in bonds including steady income, portfolio diversification and capital preservation. Bonds can provide meaningful income to retirees, help investors to ride out market downturns and decrease portfolio volatility.

Steady Income

One of the main benefits of investing in bonds is the regular income you’ll earn based on the payment schedule of the bond. This income is useful for investors who are retired or seek more income from their portfolio which can be spent or reinvested.

Capital Preservation

Bonds, if they have a high credit rating or are government backed, are less volatile and useful for preserving capital when compared with stocks. If they’re corporate or government bonds, there’s a high likelihood you’ll receive back your principal with interest, making bonds ideal for short or medium-term investors.

Portfolio Diversification

Bonds can help to diversify a portfolio if it’s more equities heavy, especially if the investor is a retiree who needs more stability and income generation. This diversification is useful during market downturns, especially as generated income can be used for expenses, to offset stock sales or to invest in equities at low prices.

Lower Volatility

Bonds, like government and corporate bonds, can deliver stability to your portfolio as they’re less volatile than stocks. Between lower volatility and income generation, bonds are an attractive investment for those who are risk averse, like retirees.

Tax Advantages

For investors seeking higher tax efficiency, bonds including Treasuries and municipal bonds are an excellent choice. Treasuries are exempt from state and local taxes while munis are often fully tax-free, helping to juice your post-tax returns.

Risks Of Investing In Bonds

While they’re often considered a safer investment than equities, bonds are not risk free and do carry some downsides, especially junk bonds. Below are the four main risks of investing in bonds from interest risk to liquidity risk.

Interest Rate Risk

When interest rates rise, bond prices, especially prices of longer-term bonds, can fall. If you think interest rates may rise, it may be smart to invest in shorter-term bonds or to consider building a diversified portfolio of bonds with different terms and risk profiles to ride out interest changes and corresponding bond price decreases.

Credit Risk

A risk which is especially associated with junk bonds is the risk of default. For this reason, you should consider a corporate or junk bond’s credit rating before you invest. While the coupon may be attractive, losing some or all of your principal can be harsh depending on your investment amount and portfolio construction.

Inflation Risk

A hidden risk of bonds is that inflation over time can reduce your purchasing power from bond interest payments, especially fixed-income payments. This is why it’s important to balance bonds in your portfolio with growth-oriented equities to outgrow inflation.

Liquidity Risk

A final risk with bonds is liquidity risk which is essentially that some bonds may be hard to sell without taking a loss to your principal under certain conditions. This is primarily a risk with corporate, municipal and junk bonds. Treasuries and bond funds are more liquid and carry this risk less.

How To Buy Bonds

Buying bonds is relatively simple, whether you’re purchasing them as individual bonds via a brokerage account or through the Treasury Department’s own website. When you’re purchasing a bond or bond ETF, make sure to consider factors like credit rating, how much you’re comfortable investing and your individual tax situation and how a bond investment may affect it.

1. Choose Your Platform

You can invest in bonds through your own brokerage account, by purchasing Treasuries through the TreasuryDirect website, or by requesting a bond purchase through your financial advisor. When choosing a platform, consider any fees which may be incurred, which bonds are available and requirements by the account. For example, TreasuryDirect doesn’t charge fees but a brokerage account allows you to invest alongside other investments in your portfolio.

2. Decide What Type of Bond You Want

Now that you have your platform selected, choose the type of bond you’d like to invest in, whether you’re interested in purchasing Treasuries, corporate bonds or shares of a bond fund or ETF. Base your purchase on whether you’re seeking tax-advantaged income, higher interest payment payments in exchange for more risk or low risk government bonds, as well as your investment horizon.

3. Set Your Budget

Next, set your budget to determine how much you can and want to invest. Certain bonds like Treasuries have a minimum investment of $1,000, while bond ETFs and funds have lower investment minimums. When making this determination, consider the rest of your portfolio and what percentage and risk level this will be in the scheme of your overall portfolio.

4. Research the Bond or Fund

Once you’ve determined your preferred bond type and budget, consider the yields, maturity dates and risk of the available bonds. If you’re considering a bond fund, check the fees and portfolio of your fund options.

5. Place Your Order

When you’re ready, you can place your individual bond or bond fund share purchase through your brokerage or advisor. If you’re considering Treasuries, you can purchase through TreasuryDirect.

6. Monitor Your Investment

Now that you’ve made your bond investment, track performance either in your platform or through your financial advisor, as well as the record of interest earnings and when the bond will mature. As your bond matures, pay attention to factors like interest rate trends to consider if you need to make any portfolio changes and consider your next investment at maturity when your principal is returned.

There are a broad range of bond options available, ranging from safe investments like Treasuries to risky but high income-generating options like junk bonds. When considering which bonds to add to your portfolio, you should consider your portfolio’s existing risk level, your primary aim with investing in bonds, and whether you want to actively invest in individual bonds or simply gain exposure with a bond fund. A safe rule of thumb is to start small with your initial investment or invest in a bond fund, as you gain confidence in investing in this asset type.