When you're looking to benefit from an investment that's a little more assured than stocks, consider adding bonds to your portfolio.
What Are Bonds?
In purchasing a bond, you are essentially loaning someone money - just as when you take a loan out from a bank, the bank expects not only the amount you borrow to be paid off but in most cases, the bank benefits from being paid interest on its loan. In the case of bonds, you are essentially the bank lending the government or corporation money. The difference between this and investing in stocks is primarily that purchasing stocks gives you a share in the company's profits, but also the risk. Bonds attract investors because they are seen as less risky, promising a "fixed" amount of interest until the bond matures, and paying back the initial borrowing at maturity as well.
There are four major types of bonds you can buy, and one way to buy bonds is by proxy. The major types of bonds, from "safest" to "risky" are:
- Federal government bonds
- Municipal bonds, call "munis" for short
- Investment-grade corporate bonds
- High-yield (formerly known as "junk") bonds
It can be harder to diversify a bond portfolio than a stock portfolio because bonds are typically sold in $1,000 increments. But there is a way around this: there are Exchange-Traded Funds that focus on bonds. These ETFs, as they're known, can provide diversification to exposure to the types of bonds that attract you, and you can compile bond ETFs like "mix and match" six-packs, allowing you to have a wide variety even if you can't invest thousands of dollars at any given time. If you find a low-cost ETF, you save yourself a good deal of money while not tying up all your investment funds in one type of bond.
Federal government bonds: Bonds with the least risk involved are Federal government bonds. Most financial advisers consider U.S. government bonds among the safest in the world - a reason they carry a very low-interest rate compared with others. The U.S. government even issues "zero-coupon bonds," sold to investors at a discount to face value, redeemable at face value on maturity but that pay no cash interest on the borrowing.
Municipal bonds: Considered the next-safest are municipal bonds. These bonds, issued by municipalities, like U.S. government bonds, are among the lowest-yielding bonds around, but the benefit in addition to interest they bring to investors is that they are non-taxable. The after-tax yield may wind up higher than on a higher-yielding bond.
Investment-grade corporate bonds: When companies with good to excellent credit ratings - as determined by rating agencies - need to raise funds, they often will issue bonds. The relative safety of such bonds suggests their interest rate will be less-than-speculative, but because they are issued by a corporation for its financing and investment purposes, they will typically pay more than the U.S. government bonds.
High yield bonds: If you want the highest yield, rather than just getting your initial investment back plus some interest, there are high-yield bonds. Formerly referred to as "junk" or "speculative" bonds, these typically pay a premium for the fact they are a greater risk to investors - in other words, you have less assurance of getting your initial investment back when they mature.
How to Buy Bonds
You can buy U.S. government bonds either on the secondary market or directly from the Federal Reserve. If you purchase a government bond from the Federal Reserve, there are no broker commissions, but you must buy new issues. And the U.S. Treasury holds regularly schedule auctions four times a year: the first weeks in February, May, August and November. As it is an auction, you must enter a bid for the various bonds being sold.
Dealers sell new-issued corporate bonds. Corporate bonds are issued by everyone from public utilities to private-sector companies. Essentially, any company wanting to raise money from investors without having to issue stock or borrow more from a bank will issue bonds. The corporate bond market for that reason is very large and active.
When a new bond is issued its face value - what will be paid back to investors when it matures -- is fixed. But once issued, the price of a bond can fluctuate in the secondary market. This is why yields and prices have an inverse relationship: often, if the price of a bond declines, its yield rises to attract investors; if a yield drops, its price may rise because more investors are purchasing them. When bonds are first issued, dealers assist whoever issued them in selling them to investors. Bond dealers make money on commissions from the proceeds of the sale of bonds to investors.
You can purchase older bonds - as opposed to new issues - from brokers on the secondary market. The secondary market includes the over-the-counter markets, such as the Nasdaq, and stock exchanges like the New York Stock Exchange. The over-the-counter markets, where most bonds are sold, encompasses financial institutions and brokerages selling and buying bonds over the phone or electronically. Brokerages that deal in bonds have the flexibility to set prices for the bonds they sell. But all prices are negotiable. Most over-the-counter bonds are for amounts over $5,000.
What to Know Before Buying Bonds
Here are tips for buying bonds, suggested by the Financial Industry Regulatory Authority (Finra):
- Don't aim for the highest yield: This is, according to Finra, the biggest mistake bond investors make. Remember that a bond offering a high yield may be riskier as an investment, which is why the yield is so high in the first place - to attract investors. Often, it could be indicating a bond with lower credit quality.
- Don't speculate on interest rates: Decisions are made too often by inexperienced investors based on where rates were rather than where they appear to be heading.
- What is your objective? Are you hoping to have enough money for a child or grandchild's college education? Do you want a better-defined return for retirement? Try to define your financial goals as precisely as you can before looking at investing in anything.
- Consider how much risk you can tolerate: Different bonds and bond funds carry different risks. If it keeps you up at night, it's not worth it.
- If you want to buy individual bonds: Find a firm and broker that specializes in bonds. Make the broker you choose aware of your objectives and risk tolerance. And ask the broker when the bond last traded, at what price, to give you an idea of the bond's liquidity and competitiveness of pricing.
- If considering a bond fund: Read the prospectus with an eye for parts that discuss the individual types of bonds in the fund. For example, not all government bond funds only hold government bonds.
How Much Money Can You Make From Buying Bonds?
Bonds are considered a less risky investment than stocks but are not as stable as certificates of deposit or money market accounts. Because of their usually less-volatile nature, and guaranteed return, you aren't going to see your investment grow rapidly, as with a stock in a bull market.
Bonds are attractive for a diversified portfolio because they provide a steady source of interest payments, usually twice a year, during their lifetime, and your principal will be returned at maturity. But holding a bond to maturity isn't the only way to make money with bonds. You can also sell it at a higher price than what you paid. Remember, bond prices move inversely to yield. So, if investors are purchasing a certain bond, its price will go up as its issuer needs to pay less interest to attract lenders. You could purchase bonds at or even below face value, and sell them when the price rises enough to profit from your original amount.
To evaluate a bond you're interested in purchasing, you'll want to know its interest rate yield (how much of a percentage of your principal will it pay you usually every six months until it matures), its maturity date (the date at which you will receive your principal back), and redemption terms.
Bonds trade at a premium, discount, or par with their face value.
If a bond is trading at a premium, prevailing interest rates are lower than the yield of the bond. So the bond is trading at a higher amount than its face value. If a bond is trading at a discount, the price is lower than its face value. This is usually an indication that the bond is paying a lower rate than the prevailing interest rate in the market. There is usually less demand for a bond with a lower interest rate, as higher interest rates can be obtained in other "fixed-income" securities. A bond with a price at par is trading at its face value - the value at which the issuer will redeem the bond (pay you back your principal) at its maturity.
Some bond issuers allow an investor to redeem the bond early - before its date of maturity. This allows the issuer to take advantage of falling interest rates to refinance its debt, like paying off a mortgage to refinance your mortgage at a lower rate. There are also sometimes a call provision, which allows the issuer to redeem the bond at a specific price at a date before its maturity, or a put provision, which makes it possible for an investor to sell the bond back to the issuer at a specified price before maturity.
Because you are taking on a risk that the bond will be redeemed and you'll have to reinvest at a lower interest rate, a call provision often pays a higher interest rate.