As an investor, you have to decide where and how to invest your money. Many people choose to invest in stocks and/or real estate to build wealth.
While history shows these are solid investment strategies over the long haul, they both come with some risk in the short-term.
If you don’t mind some risk for a potentially higher return, these two choices should be acceptable. Alternative investments should always be carefully considered because of the financial risks and possible tax consequences involved.
Are you more conservative and somewhat risk-averse investor? Then you may want to direct your investment dollars towards an investment vehicle offering a steady return with substantially lower risk. This is where buying bonds come in.
If you are curious about bond investing, read on to learn more about the topic. It’s important to understand the choice you’re making if you do decide to buy individual bonds or invest in bond funds.
What Are Bonds?
When you need cash to buy a home, or for unexpected expenses, you go to a lender and borrow money. Like you, businesses and government organizations sometimes need to borrow money.
Borrowing from a traditional lender is not always the best option because of high-interest costs and certain borrowing restrictions. When an organization needs to borrow, they can go straight to the investment community and sell bonds to raise cash.
A bond is a financial instrument to show agreement between a borrower and a lender. It’s similar to a promissory note in that it states the amount borrowed, the interest rate, a specified payment schedule, and due date.
Making Money From Bonds
There are many variations of bonds with a number of things differentiating one from another. At the most basic level, you’ll see a standard bond with terms dictating how income is paid based on a stated interest rate.
Example: Company A needs to borrow $100,000 for a research project. They decide to sell 10 $10,000 bonds that bear interest at 3% annually, payable every six months until the principal is due, typically 10-20 years from the date the bond is issued.
The other popular income option is a “zero-coupon” bond. This type of bond does not pay interest and does not offer incremental payments. Instead, the bond issuer will sell the bond at a stated principal, discounting the selling price. The difference between a bond amount and the discounted selling price is the profit margin.
Example: Company B sells 10 $10,000 bonds at a discounted price of $9,000 per bond. Upon maturity of the bond, the company will pay the bondholder $10,000 for the bondholder’s investment of $9,000. The investor’s profit over the term of the bond is $1,000, or just over 11% over the life of the bond.
Type of Bonds
When you purchase a bond, there is no collateral. You are making an investment backed solely by the financial strength of the bond issuer. With this in mind, you need to know what kind of bond you are buying.
The three primary types of investment grade bonds are:
- Treasury Bonds. Issued by the US federal treasury to repay maturing debts. Backed by the faith of the US government. These are low-yield bonds, but they are also very low risk for investors.
- Municipal Bonds. Bonds issued by cities, counties or states. A local government agency usually issues these “munis” (bonds) to raise money for community projects. These relatively low-risk investments are tax exempt from federal income tax. In some cases, state and local income tax is exempt too. But when interest rates rise, market prices of existing bonds drop. Should you not hold the bond to maturity, you risk selling it at a reduced price.
- Corporate Bonds. Issued by a corporation to raise money for business-related expenses or to repay other debts. They tend to offer higher interest rates than other bonds, but then come with higher risk too.
How to Buy and Sell Bonds
Bonds can be bought individually or in a mutual fund or exchange-traded fund (ETF) that invests in bonds.
Treasury bonds may be purchased directly from the US government by any legally competent person 18-years or older, with a valid Social Security, U.S. address, and U.S. based bank account. There are no fees or price markups when purchasing bonds through Treasury Direct.
Should you wish to sell a Treasury bond held at Treasury Direct before its maturity date, you would need to transfer the bond to a bank, broker, or dealer, to sell it for you.
Corporate and municipal bonds, as well as Treasury bonds, can be purchased and sold through a brokerage. Many online and big-name brokers like Charles Schwab, Fidelity, or Ally Invest offer many bond options.
The brokers set the price based on several factors, including remaining time to maturity, along with supply and demand. You may find bond prices varying greatly between brokerages due to these markups and brokerage fees.
Bond Mutual Funds or ETFs
Investing in individual investment-grade corporate bonds, municipal bonds, and Treasury bonds can provide reliable income, but it may not be enough diversification for some investors.
It may also require more capital, research, and monitoring than most investors would like. Deciding to invest in managed bond funds may be a better option.
Bond funds are similar to stock funds in that a professional fund manager combines money from individual investors and uses it to purchase investments they believe will best deliver the stated goals of the fund.
Like stock funds, bond funds may look to mimic the market, through short- and long-term bond investments from a variety of sources, such as various corporations and government agencies, as well as the U.S. government. Or bond funds may instead seek a mix of short-term Treasury bonds or a mix of corporate high yield bonds.
Either way, these bond funds are investing in differing securities achieving diversification reasonably easily with a smaller investment. While some bond funds may be riskier investments, they may also offer higher returns. This can balance out safer and lower-yield individual bond investments.
Bond fund managers are buying and selling securities within the fund often, rarely holding any bonds to maturity. This means the monthly income from the fund can vary, and you could even lose some or all of your initial investment in a bond fund depending on how long you hold your shares.
If you sell a share of your bond fund, you receive its current net asset value (NAV), or the value of the fund’s holdings divided by the total number of shares in the fund, less any applicable fees.
How Bonds Are Rated
The only way to get an idea of the quality of the bond you are purchasing is to look at the bond’s rating. There are three primary organizations rating bonds: Standard & Poor’s, Moody’s, and Fitch.
While each of these organizations might use slightly different criteria to arrive at a rating, the ratings come out pretty much the same. Bonds are rated between AAA (highest grade) and D (lowest grade) by Standard and Poor’s and Fitch and only down to C for Moody’s.
Higher ratings suggest the issuer has the financial ability to make interest payments and repay the loan in full at maturity. Almost all treasury bonds are rated AAA because of the economic strength of the US government.
The ratings for corporate and municipal bonds depend a great deal on the solvency and financial strength of the bond issuer. The lower the rating, the greater the interest rate or return will likely be. This helps to compensate investors for the additional risk associated with these bonds.
The reason bonds increase and decrease in value is directly related to how the bond issuer is performing financially at any given point in time.
Pros and Cons of Buying Bonds
As there is with any other kind of investment, there are pros and cons that come with investing in bonds.
Let’s start with the pros:
- Safer Investment. Using the bond’s rating as a guideline, you can determine the level of risk you are willing to accept for a predetermined return. For the most part, bonds are very safe investments.
- Predictable Income Stream. If your investment goal is to create a steady stream of monthly income, bonds would be a preferable option.
- Personal Investment Choices. Potential to make a direct investment in your local community or a corporation you want to support for personal reasons
And now for the cons:
- Lack of Liquidity. As a stable investment instrument, you are being asked to lock your money in for as long as 10 years. If you need to sell a bond early, it could be challenging to raise cash quickly if the demand is small, causing you to have to discount the price
- Opportunity Cost. If you lock into a bond at 3% per annum, you run the risk of not being able to invest that money in another type of investment offering a higher return. That includes other future bonds that bear higher interest rates due to different market conditions.
- Playing It Safe Without a Guarantee. Bonds have a low return for an investment that is not 100% risk-free, though they are still extremely safe at the higher ratings.
Does Building a Bond Ladder Make Sense For Me?
Similar to building a certificate of deposit (CD) ladder, you can also build a bond ladder. This might make sense if your goal is to manage interest rate risk and create a predictable stream of income. An investor using a bond ladder strategy builds a portfolio of fixed-income securities with staggered points of maturity.
Stable, high-quality bond laddering provides regular access to assets. You can structure bond ladders to mature every month, quarter, or year – depending on your financial situation. As long as you hold the bonds to maturity, you have the flexibility to reinvest the principal or use it for other purposes.
You can learn more about bond ladders on the Charles Schwab website and as always, discussing your financial goals and strategies with a trusted professional is suggested.
How Much of My Portfolio Should I Invest in Bonds?
Bonds offer stability and income. But the further away you are from retirement, the more you need to consider the long-term growth potential of stocks.
But longer life expectancies have financial professionals updating suggestions for asset allocations. Now, some say using 110 or even 120 minus your age makes more sense. The longer you need your money to last, the more growth you’ll need. And stocks historically provide that growth over time.
The advice and suggestions above are just “rules of thumb,” and they may work for your financial situation. Seeking the services of a trusted and experienced financial professional is what we suggest if you need retirement planning education and advice.
You can also use online tools to learn more about how varying asset allocations could affect your investment portfolio.
- Vanguard offers an investor questionnaire to help you decide what percent of your investments should be in stocks, bonds, and other investments.
- Bankrate also has an Asset Allocation Calculator to help you create a balanced portfolio that considers factors including your age and risk tolerance.
Final Thought: If you’re risk-averse, you’ll definitely want to consider investing in bonds, low return and all. However, it might be better in the long term to accept more risk for higher performance.
This is especially true for younger investors who have plenty of time to ride the waves of ups and downs one might experience when investing in stocks or real estate.