Maybe you’re intrigued by the idea of how to invest in bonds, but at the same time, the bond market doesn’t seem as straightforward as the stock market.
Bonds can seem complex relative to stocks. The global bond market is about three times the size of the global stock market, and it’s much more fragmented. Bond investing may seem daunting, as the metrics used to gauge the quality of a bond are quite different from those of stocks, and are not familiar to as many investors.
Fortunately, it’s not difficult to learn enough bond basics to add these fixed-income securities to a portfolio successfully.
What are bonds and how do they work?
In a nutshell, bonds are loans investors make to governments or corporations in exchange for regular interest payments and the return of the initial investment, or principal, when the bond matures.
Bonds are generally considered less risky than stocks and can provide a steady, fixed income, which is often appealing to retirees who appreciate the predictability of income over the volatility of growth stocks.
“Not to be cavalier, but bonds are often referred to as investments ‘for widows and orphans’ because they are generally thought to be safe, but the devil is in the details,” said Matt Willer, managing director of capital markets and partner at Phoenix Capital Group in Denver, Colorado.
“Bonds are debt instruments issued by an issuer to investors. They are almost exclusively used for financing something in lieu of a bank or issuing stock that dilutes ownership,” Willer said. “Think of it as a loan, where the bondholder is the lender, and the issuer is the borrower.”
While bonds, as a broad asset class, are less risky than stocks, they still carry some degree of risk, primarily related to interest rate fluctuations or credit quality.
Types of bonds you can invest in
You can find bonds in many flavors, with some of the most common being:
Government bonds
These bonds are issued by national, state or local governments. For example, United States Treasury bonds are considered among the least risky investments, as they are backed by the US government.
Treasury bonds
These are long-term debt securities issued by the federal government, providing fixed interest payments over terms of 20 or 30 years. Investors can buy this type of government bond directly from the US government via its TreasuryDirect website or through brokers.
Corporate bonds
Corporate bonds are offered by corporations to raise capital. Corporate bonds vary in risk, depending on the issuer’s creditworthiness, or their ability to pay interest and repay an investor’s principal.
Municipal bonds
Issued by state or local governments to fund public projects, municipal bonds, frequently dubbed “munis,” are government bonds that often provide tax benefits. Muni bonds can generally be purchased through a brokerage or financial advisor.
Treasury Inflation-Protected Securities (TIPS)
As the name suggests, TIPS are government bonds designed to protect against inflation by adjusting the bond’s principal value according to changes in the Consumer Price Index (CPI), as measured by the Bureau of Labor Statistics (BLS).
Mortgage-backed securities (MBS)
These are debt securities that bundle home loans, offering investors exposure to the income from mortgage payments, with varying levels of risk.
Series I savings bonds
I bonds are savings bonds issued by the US Treasury, offering a combination of fixed and inflation-adjusted interest. Investors can purchase I bonds directly from the TreasuryDirect website.
Benefits and risks of investing in bonds
Bonds offer greater stability than stocks, along with regular income. On the whole, they’re less risky than stocks, provide a reliable stream of income and act as a cushion against market volatility. That means bonds are appropriate for risk-averse investors seeking steady returns.
In addition, if the company that issued a corporate bond files for bankruptcy protection, bondholders are in line to be paid before stockholders. That offers bondholders more security and a higher chance of recovering their investment.
However, bondholders are left in the lurch if a company can’t pay its debt.
“The risk is default and, therefore, the issuer’s credit quality is critically important, as well as understanding where the particular bonds fall in the priority line,” Willer said.
For example, in some cases, other obligations are paid out first in an insolvency or bankruptcy. Secured creditors, such as banks, are generally first in line.
| Benefits | Risks |
|---|---|
Provide more price stability than stocks | Generally trail stocks in terms of price appreciation |
Offer regular income payments to bondholders | Come with interest-rate risk, as higher rates translate to lower bond prices |
May reduce overall portfolio volatility | Carry credit risk, or the chance that an issuer will default on interest payments |
Bondholders have a greater chance to recover their investment if the issuer files for bankruptcy | Secured creditors may be paid ahead of bondholders if the issuer becomes insolvent or files for bankruptcy |
Where and how to buy bonds
If you have a brokerage account, the process of buying bonds isn’t all that different from buying stocks. However, investors have some other options to purchase bonds directly.
According to Nick Srmag, senior portfolio manager and managing director at MAI Capital Management in Cleveland, Ohio, when bonds are bought through a broker, “There are usually fees or commissions associated with this route.”
He added that investors can also use a brokerage account to purchase shares of exchange-traded funds (ETFs) that track or own bonds.
“This vehicle allows investors to get exposure to bonds from different companies,” Srmag said.
He added that investors can use the TreasuryDirect website to buy government bonds without paying a broker’s fee.
“Investment advisors may offer a lower cost solution to purchasing bonds for you,” he said.
Financial advisors can access bond markets efficiently, offering cost-effective options and tailored strategies. An advisor can help allocate bonds in a way that aligns with investors’ other holdings and investment objectives.
How to evaluate bonds
One handy way to evaluate bonds is by using ratings developed by agencies like Fitch, Moody’s or Standard & Poor’s.
These ratings, which are widely used by professional investors, evaluate a bond issuer’s creditworthiness and the likelihood of default.
Bonds with higher ratings, such as AAA or A, are deemed to be safer but typically offer lower yields.
On the flip side, bonds with lower ratings, such as BB or B, generally offer higher yields but carry greater default risk. The higher yield is the tradeoff as investors demand a more sizeable return for taking the extra risk.
Investment grade ratings scales
| Fitch | Moody's | Standard & Poor's |
|---|---|---|
AAA | Aaa | AAA |
AA | Aa | AA |
A | A | A |
BBB | Baa | BBB |
Speculative/noninvestment grade ratings scales
| Fitch | Moody's | Standard & Poor's |
|---|---|---|
BB | Ba | BB |
B | B | B |
CCC | Caa | CCC |
CC | Ca | CC |
C | C | C |
RD | D | |
D |
Understanding bond quotes and their basics
Like a stock quote, a bond quote provides all the important pieces of information an investor might want to know about a particular bond, including the bond’s issuer, its coupon rate, maturity date, bid-ask spread and yield.
Here are some definitions for investors new to bonds:
- Coupon rate: A fixed annual interest rate, paid semi-annually, to bondholders
- Maturity date: The date when the bond’s principal is repaid
- Bid-ask spread: The difference between buying and selling prices
- Yield: A bond’s annual return on investment
A bond quote gives a buyer or seller the current price at which a bond is trading.
It’s typically presented as a percentage of the bond’s face value, said Smag, which is the amount the bond will be worth at maturity, or the end of the loan term. A bond’s face value is also known as “par value.”
Srmag added that a bond’s par value is traditionally set at 100, representing 100% of a bond’s $1,000 face value.
“While price is important when purchasing bonds, as it determines your total outlay, investors should also focus on the expected yield to worst,” he said.
“Yield to worst” is the lowest potential yield an investor could receive if the bond performs poorly or is called early.
Strategies for bond investment
Most investors aren’t as familiar with bonds as they are with stocks. After all, you won’t find many TV shows, YouTube channels or online trading courses dedicated to the bond market, as you do with stocks.
That makes it imperative for new bond investors to do their homework or seek help from an advisor.
“The bond market can be difficult to understand, and the best thing an investor can do is consult a financial advisor about how best to fit them into their portfolio,” said Srmag.
Investors could incorporate passive strategies such as indexing or bond laddering, he said.
Bond indexing simply means constructing a portfolio to mirror the performance of a predetermined basket of fixed-income securities. For example, the Vanguard Total Bond Market ETF (BND) tracks the Bloomberg US Aggregate Float Adjusted Bond Index. It offers investors exposure to the broad US bond market, including government bonds, Treasury securities, corporate bonds, mortgage-backed securities, asset-backed securities and municipal bonds.
Bond laddering refers to a strategy of buying bonds with staggered maturities. That spreads out interest-rate risk and helps investors maintain liquidity.
Investors might also consider a mutual fund that takes a more active approach to picking out specific bonds that the investment manager believes will perform well over time.
Kendall Meade, a certified financial planner (CFP) at San Francisco-based SoFi, said investors might consider matching a bond’s maturity date to their investment timeline.
“For example, if you need your principal in five years to make a down payment on a house, you may not want to buy a 10-year bond,” she said.
If an investor were to sell a 10-year bond after five years, he or she may find it less valuable than if it were held to maturity.
Alternatives to bonds
Investors seeking a stable source of income have options in addition to bonds.
Those alternatives include:
- Certificates of deposit (CDs): These are fixed-term investments, typically offered by banks, with guaranteed interest rates.
- High-yield savings accounts: As the name suggests, these savings vehicles offer higher rates than typical bank accounts. Frequently, online banks pay higher rates than brick-and-mortar financial institutions.
- Dividend-paying stocks: Dividend stocks typically have higher absolute returns than bonds. However, stocks are more risky than bonds, and investors choosing this option should be prepared for greater volatility.
Frequently asked questions (FAQs)
Bonds are often suitable for investors who want income and greater stability than they’ll find with stocks. However, be aware that stocks, as a broad asset class, generally deliver higher returns than bonds.
You can buy Treasury bonds directly from the US Department of the Treasury’s TreasuryDirect website or through a brokerage account.
Yes, bonds can and sometimes do decline in value. Typically, bond prices decline less than stocks, but as interest rates rise, bond prices decline.
This is called interest-rate risk, and it occurs because existing bonds become less attractive compared to newer bonds offering higher yields. If an investor wants to sell an older bond with a relatively low interest rate, they may have to do so at a discounted price.
A bond quote contains essential information about a bond that a buyer or seller might seek. That information includes the bond’s name, its issuer, its coupon rate, maturity date, bid-ask spread and current market price.
