By: Eric Rosenberg
Updated: December 11, 2019
If you want to learn how to invest in bonds, you’re not alone. After all, they’re an essential part of most well-managed long-term portfolios. Read this guide if you want to know about investing in municipal bonds, corporate bonds, or federal government bonds.
How to Invest in Bonds: The Basics
First off, what are bonds? They’re a form of debt in which investors lend money to a company or government. Bonds often come in $1,000 or $10,000 increments.
Bonds are an essential part of the economy and a popular method for businesses and governments to raise funds. The proceeds from bond issues fund factories, roads, schools and government operations. Bonds reach into most parts of finance, including banking and real estate.
In the past, corporate bonds earned a reputation for less volatility and more stable returns than stocks. However, that opinion is slowly shifting as bonds behave more and more like stocks. In any case, they remain a popular and important part of the investment landscape.
Although most bonds have fixed interest rates that are locked in when the bonds are issued, their prices are still affected by market interest rate changes. As market interest rates rise, a bond’s rate seems less appealing by comparison. So the price of that bond drops.
ETFs and Mutual Funds Are a Great Way to Invest in Bonds
If you don’t want to buy individual bonds, you’re in luck. The best way to buy bonds is often through a mutual fund or exchange-traded fund (ETF). Many brokerages now offer free ETF trades. This may be the most cost-effective way to invest in a diversified bond portfolio.
If you buy fixed-income funds (fixed-income is a term often used for bonds) or any other type of ETF or mutual fund, pay attention to the fees the fund charges. Those may silently eat away at your earnings without your realizing it.
Bond funds come in a range of varieties. Some general investment funds, such as target-date funds, could hold a combination of stocks and bonds.
Investing in U.S. Government Bonds
U.S. government bonds are the closest thing you’ll find to a risk-free investment.
However, there’s a trade-off: Because they’re considered very safe, U.S. government bonds pay among the lowest interest rates of any type of investment.
Government bonds come in many forms. You may have savings bonds stashed away from a gift when you were a kid. This is a type of government bond. But with bigger dollars, more types of government bonds are available.
Examples of types of U.S. government bonds include:
- Savings Bonds: Most savings bonds held for 20 years mature to their face value, double what was paid for them.
- Treasury Notes: Treasury Notes mature after two to 10 years, with a face value of $1,000 or $5,000.
- Treasury Bonds: Also called T-bonds, U.S. Treasury bonds mature after 10 to 30 years. They come with a $1,000 face value and pay a coupon (interest payment) twice per year. They’re a significant part of U.S. monetary policy.
- Treasury Inflation-Protected Securities (TIPS): These bonds give investors inflation protection in their bond portfolios by floating with current interest rates.
Investing in Corporate Bonds
Corporate bonds are one of the two most common ways for big businesses to raise money. (The other is issuing new stock.) But unlike stock, managers don’t have to give up a stake of ownership in the company when they issue bonds. Instead, bonds are a tool that raises money that has to be paid back.
Interest rates on corporate bonds vary based on the underlying company’s credit rating. Standard & Poor’s (S&P), Moody’s and Fitch are the three big credit rating agencies for bonds. BBB and above signifies “investment grade” on both S&P’s and Fitch’s scales. Ratings below that threshold are called “junk bonds” and carry higher interest rates for the higher risk.
Corporate bonds are much riskier than government bonds. If something goes wrong at the federal government, it controls the money supply and can ultimately pay off any U.S. debt. But companies can go bankrupt and miss payments. For example, Sears bonds dropped significantly in value when the company went bankrupt in 2018. Some bonds may be canceled or reduced in value during bankruptcy. So you should always take care when choosing where you invest.
Most corporate bonds are a $1,000 IOU. Some pay interest throughout the life of the bond, while others pay back all the interest with the principal in a lump payment at the end.
Investing in Municipal Bonds
Municipal bonds, or muni bonds, are a type of bond issued by states, cities, counties and other government entities as a form of fundraising. Muni bonds have one very popular feature: They’re often tax-free. That means you can earn income without paying income tax on your investment profit.
Municipal bonds may be somewhat low risk, but they’re not the same as U.S. government bonds. Unlike the federal government, cities and local governments do go bankrupt from time to time. Detroit, Stockton, Calif., and San Bernardino, Calif., have gone through bankruptcies, as has Boise County, Idaho. In those cases, municipal bondholders were at risk.
As with all other investments, you should research and understand the risks and expected returns before investing in municipal bonds.
If you have a diverse retirement portfolio, you could own bonds and not even know it! Look at your 401(k), IRA, or other retirement accounts to find out exactly what you have in them.
If you manage things well, bonds should be a big part of your long-term financial plan.
Written by Eric Rosenberg.
View the original article at here.