Bonds aren’t sexy and exciting like stocks, so most folks don’t want to have this conversation. You asked for it. Any time someone searches for “how to invest in bonds,” they are just begging for this spiel. Are you ready? Grab a cup of coffee. This will take a few minutes. Don’t let that scare you away, though. I can guarantee a legitimate return on your time investment today.
Let’s get one thing straight before we begin. Bonds are not an “alternative” to stocks. I hear stories all the time about investors looking to “minimize downside” by converting their equity investments into “safer” bond alternatives. That’s a valid strategy, but if you invested properly in the first place you would never have gotten to that point.
Savvy investors use bonds to create a “balanced” portfolio. Equities (stocks) go up and down frequently based on market conditions. Bonds are more stable. You buy them for a certain amount, collect a fixed interest payment typically twice a year while you hold the bond, and then hopefully cash them in at maturity for what you paid for them. Seems simple, right?
In a balanced portfolio, bond stability is supposed to balance equity volatility. In May of 2009, when the stock market was at its lowest point in two years, the bond market was up 7.82%. If you carried a 60/40 balance in your portfolio, stock losses were mitigated by bond gains. Most investors know this principle. Few understand exactly why it happens.
What Are Bonds And How Do They Work?
“I’ll gladly pay you Tuesday for a hamburger today.” If you’re smiling right now, you’re old like me. For our younger readers, the quote is a line from a Popeye cartoon character by the name of J. Wellington Wimpy. He’s asking for no-interest credit. We’ve all done it. I’ve borrowed twenty bucks from a friend, offered to swap shifts on the job, and traded TV time with my spouse. The payback in each of these instances was equal to what was borrowed. No interest charged.
Now, imagine for a moment if the response to Wimpy’s inquiry was, “I’ll give you that $1 hamburger today, but you have to pay me $1.25 on Tuesday.” That is what a bond is. Corporations, municipalities, and governments often need to raise money to cover expenses. Rather than take on debt from a bank or lending institution, they sell bonds, usually in $1000 increments. The money they receive is essentially their “hamburger.”
There’s more. Remember, Wimpy had to pay extra because the lender waited days to get paid. When you buy a bond, you pay the face value and agree to wait for repayment. It could be several months or several years, depending on the terms agreed upon at issuance. During that time, you receive interest on your investment. Interest rates vary based on the length of the agreement and the “risk factor” of the company or institution you’re dealing with.
The Difference Between Stocks And Bonds
If a company’s net worth is $1 million and they issue 100,000 shares of common stock, each of those shares is worth $10. Shareholders in that company are betting on management to increase the overall net worth so the value of company shares go up. Unfortunately, it doesn’t always work that way. Sales, cost of goods sold, and other factors beyond the control of management can cause the value of a company to go down, thus lowering the share price.
Bonds don’t work that way. The face value of the bond remains the same regardless of market conditions. At maturity, you’ll be repaid that amount, provided the company doesn’t go out of business. The only real risk with bonds is the interest rate. If you agree to 5% and interest rates go up to 6%, you’re taking a loss. On the flipside of that, if interest rates go down to 4%, you’re locked in at the higher rate, so you register a gain.
Bond Categories And Risk Assessment
Interest rates and corporate stability are two of the factors to evaluate when you choose to get into bond investments. There are three standard bond categories, each of which has its share of risks and rewards. The three categories are: corporate bonds, municipal bonds, and treasury bonds. Review the following for a better understanding of each.
- Corporate Bonds: Deemed by most investors as the riskiest of the three categories, corporate bonds are issued by corporations seeking to raise money to cover expenses or expansion projects. These bonds typically offer higher interest rates. The downside is the risk of financial failure. If the company goes out of business, by law you’re entitled to repayment before shareholders, but there may be no funds left to pay you.
- Municipal Bonds: Usually issued by states, cities, or towns, municipal bonds or “Muni Bonds” as they are often referred to, come in two categories. “General Obligation” muni bonds give the municipalities more leverage for payback. They can increase taxes or sell assets to repay bondholders. “Revenue” muni bonds are tied to specific revenue sources, like toll roads or ticket sales. Interest on both of these muni bonds is IRS tax exempt.
- Treasury Bonds: The interest on US Government issued T-Bonds is taxable at the federal level but exempt from state and local taxes. T-Bonds typically offer the lowest interest rates of the three categories, but they’re deemed the safest. Treasury bonds are also the only type of bond you can buy direct. Corporate and Municipal bonds can only be obtained from a bond broker, so pricing can vary between sources. FINRA regulates the market somewhat by posting current bond prices daily.
Each bond, regardless of category, is rated by a lettering system with AAA or Aaa being the highest and C or D being the lowest, depending on who is doing the rating. Rating systems are coordinated and managed by Standard & Poor’s, Fitch, and Moody.
How To Invest Bonds
Now that you have the basics down, how do you go about investing in bonds? The first step, once you know which type of bond you’re looking for, is to find out where to buy them. Any US citizen over the age of eighteen can buy treasury bonds. Corporate and municipal bonds will require that you go through a broker. Review the following:
- U.S. Treasury Department: To buy a U.S. Treasury bond, go to TreasuryDirect.gov and open up an account. You must be eighteen years old, have a valid social security number, a US bank account, and a verifiable address inside the United States. Treasury bonds are sold in $1000 increments, so be prepared to spend at least that to get started.
- Online Brokerages: Fidelity, Schwab, and TD Ameritrade have extensive bond holdings that you can browse through to buy corporate, municipal, or treasury bonds. This is a more complex process than simply going to the U.S. Treasury. There are brokerage fees and bond prices can vary between brokerages. You can also buy bonds through E-trade.
- Mutual Funds and ETF’s: A simpler way to buy bonds is to invest in mutual funds or exchange traded funds (ETF’s). These are essentially “buckets” of various investments, sometimes all-stock, or exclusively bonds, or a mix of both. The key benefit to buying bonds as part of a mutual fund or ETF is that your minimum buy-in is much smaller. You can buy these products through a brokerage or with your E-trade account. There are also apps like Acorns and Betterment with buy-ins as small as $5 per week.
Bonds are a liquid investment. For best results, you should hold your bonds to maturity, but you can sell them early if you need to generate cash. The best time to do that is when the coupon value on your bonds is higher than standard interest rates. Many investors look for opportunities to buy used bonds that fall into that category. You could be the seller, or you could look into used bonds as an investment opportunity. Research this thoroughly.
Investing In Bonds: Creating A Balanced Portfolio
Do you need a warm-up on that coffee? Don’t worry. I’m almost done. Let’s talk a little more about balanced portfolios. Now that you know what bonds are and how they work, do you understand why balancing your stock investments with bond holdings is so important? The concept of a steady income flow to offset potential losses isn’t too hard to grasp.
The information in this article should give you a firm foundation to get started. Bond investing is fun and fairly safe. Balancing a portfolio is more complicated. It involves more than just spending 60% of your money on stocks and the remaining 40% on bonds. Read up on equities and equity index products like ETF’s and options. These can help you achieve true balance and protect you from down markets. We’ll be covering more on that in the weeks to come.