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Investing in bonds is one of the primary ways to invest in the financial markets — a strategy with its own advantages and disadvantages.
Although the bond market can be complex, the underlying process is quite simple to understand.
In this article, we’ll break down the different types of bonds, how they work, who issues them, and how you can select the best bonds for your portfolio.
What are Bonds, and What is Bond Investing?
When it comes to stable forms of investment, investing in bonds is near the top of the list.
Investing in bonds can be a smart move for investors who feel that the stock market is too high and that interest rates will rise in the near future.
A government or a corporation typically issues them to raise money and pay back investors who buy bonds.
If you purchase bonds, you essentially are lending your money to the issuer, who promises to pay you interest on it, and will return the investment at a specific time in the future.
A bond is an IOU — you've loaned money, and you need to be paid back with interest.
How to Make Money From Bonds
Bonds are fixed-income securities that pay a stated interest rate over a predetermined period.
They can be any length of time, available in term lengths from 1 year to 30 years, but it typically varies from 5-20 years.
The longer the maturity, the higher the interest rates, as longer-term bonds have less interest rate risk as they offer lower yields than short-term bonds.
With bonds, your capital is at risk, and if you need your money back early, it may come at a higher cost.
How To Buy and Sell Bonds
Buying and selling bonds is a relatively simple process.
You can begin investing in bonds in a few quick steps.
Step #1: Determine your financial commitment
Several bonds can be purchased in almost any amount, so decide how much you want to invest and start slowly.
You have the option of adding more money later if you're comfortable with the investment.
The question in this step to ask is: how much of your investment portfolio do you want dedicated to bonds?
Step #2: Look for a reputable broker
When buying bonds, you'll need to work with a broker to execute the transaction.
It's vital to select a broker you can trust who will act in your best interests.
Step #3: Review the terms of the bond
Once you've chosen a bond, it's essential to review the terms before investing.
- the interest rate
- maturity date
- whether or not the bond can be paid off early by the issuer, known as “callable”.
Step #4: Buy the bond
Once you've decided on a bond and reviewed the terms, it's time to buy! You can do this through your broker or online.
Step #5: Monitor your investment
Bonds can be relatively safe investments, but it's still important to monitor them and ensure they perform as expected.
Don't hesitate to contact your broker for help if something seems off.
If you need to sell your bonds, your broker can easily handle that order for you.
Advantages of Bond Investing
Bonds come with many tremendous benefits. Here are a few.
Higher Interest Rates
The interest rates on most types of bonds are higher than interest rates offered by savings accounts at banks.
Bonds are considered to be low-risk investments. This is because the likelihood of a company or government going bankrupt and not being able to repay its bondholders is relatively low.
Another benefit of investing in bonds is that they are very liquid investments. This means that you can sell them back to the issuer (the government or corporation that issued the bond) at any time you want.
Disadvantages of Bond Investing
Bonds are a popular investment choice for many beginners because they are considered relatively low risk.
However, a couple of disadvantages of investing in bonds should be considered before making this decision. These include:
Lower Bond Yields
Bond yields are typically lower than stock yields, so you may not see as much growth potential with this investment.
Long Time Until Maturity
It can take a while for bonds to mature, so you might not receive any return on your investment for a long time.
If you're looking for a short to mid-term investment vehicle, bonds are not the best option.
5 Types of Bonds
When it comes to investing in bonds for beginners, it is important to note that not everyone will have the same objectives. Therefore, bonds are not one size fits all.
There are five main types of investment bonds, allowing you to pick the bond or bonds that work best with your financial objectives.
Issued by the U.S. government and backed by its "full faith and credit," Treasury bonds are considered by many to be one of the safest investments in the world.
U.S. Savings Bonds
Issued by the U.S. government to finance public projects (e.g., schools, roads, etc.), U.S. savings bonds are considered one of the safest investments in the world. They typically accrue interest for 30 years.
Issued by state and local governments to finance public projects (e.g., building schools, hospitals, roads, etc.), municipal bonds are tax-exempt at the federal level but may be subject to state and local taxes.
Issued by companies to raise money for various reasons (e.g., expanding their businesses, refinancing debt, etc.), corporate bonds are a type of debt security.
Agency bonds are issued by a department in the federal government (or a government-sponsored enterprise other than the U.S. Treasury) for a wide variety of national projects.
3 Ways Bonds Are Issued
There are three main ways that bonds are issued. We’ll look at each way in detail next.
In an auction, potential investors submit bids stating how much they are willing to pay for the bond.
The bond issuer then selects the winning bid, and the investor pays that price plus any accrued interest.
Another way bonds can be issued is through a private placement.
In this case, the issuer sells the bond directly to a select group of investors.
This method is often used when the bond is considered too risky or when there isn't enough time to hold an auction.
Finally, some bonds are sold through a public offering.
In this case, the bond is listed on an exchange and available to anyone who wants to buy it.
Public offerings are popular because the bond can trade on exchanges like stocks, providing liquidity for investors that want to sell it at whatever time they choose.
Bonds vs. Other Investments
When deciding whether or not bonds are right for your investment strategy, it’s important to factor in other investment choices.
We’ll look at a few next.
Investing in Bonds vs. Stocks
Stocks and bonds are two different types of investments.
Stocks are ownership shares in a company, while bonds are loans to a company.
When you buy a stock, you become a part-owner of the company and share its profits (or losses).
When you decide to purchase a bond, you're lending the company money in exchange for periodic interest payments and the repayment of your original investment at maturity.
The risks and rewards associated with stocks and bonds differ. The potential for higher returns is one reason why many people invest in stocks.
However, stocks are riskier than bonds because they can dramatically go up or down in value.
Bonds are considered less risky since the loan is repaid at maturity and the issuer pays periodic interest payments.
Investing in Bonds vs. Savings Account
Bonds and savings accounts are popular ways to save money, but they have some critical differences.
A savings account is a type of deposit account that pays interest. The interest rate is usually lower than what you would earn on a bond, but the money is more accessible.
You can withdraw funds from a savings account at any time without penalty.
Bonds and savings accounts are two different types of investments that offer different levels of risk and reward.
Bond prices can fluctuate based on economic conditions, and while small, there is some risk of loss involved with certain types of bonds.
Savings accounts are safe from financial loss unless the bank or financial institution goes bankrupt.
In that case, all deposits up to $250,000 per depositor are protected by the F.D.I.C. (Federal Deposit Insurance Corporation).
The Bottom Line: Investing in Bonds
When investing in bonds, it's essential to consider your risk tolerance — that is, how comfortable you are with potentially losing some or all of your investment.
Investing in bonds with higher yields tends to be riskier, so if you're not comfortable taking on more risk, you may want to stick with safer options like government bonds.
In general, bonds are debt securities that pay interest periodically until they mature (expire). As such, they're considered less risky than stocks — and some people think that because bonds don't "move" on the market as much as stocks do, they're a safer investment.
Keep in mind that while investing in bonds may not always work well with all investment strategies, they're incredibly effective for anyone who's seeking long-term stability without taking on too much risk.