- Buying bonds can help diversify your assets and produce consistent income.
- Bonds can be owned directly from the issuer or indirectly through a mutual fund or ETF.
- Different types of bonds provide different risk-return profiles, such as how some corporate bonds have higher yields due to greater risk of default.
To some investors, bonds aren't the most exciting assets to own. You're probably more likely to hear friends talk about high-earning stocks rather than discuss Treasurys vs. municipal bonds. But just because bonds aren't always flashy doesn't mean you should ignore them.
For many investors, bonds play an important role in building a strong investment portfolio by adding a layer of diversification and stability.
Plus, some bonds provide tax benefits over other investments while helping you find better alignment with your risk tolerance. You can invest in bonds and other assets with the best online brokerages.
Understanding bonds
"Bonds have a long history of moving in the opposite direction of the stock market during times of market volatility, helping to provide your portfolio with a smoother journey," says Shane Sideris, a chartered financial analyst (CFA) and co-founder and financial planner at Synchronous Wealth Advisors.
What are bonds?
Bonds are known as , low-risk, fixed-income assets that provide a regular income stream. Through bonds, investors lend money to governments or companies in exchange for regular payments at certain intgervals, usually semi-annually, over a set period of time.
For example, a bond might be issued for 10 years at a 4% interest rate, meaning that every year for 10 years, you (as the bondholder) earn 4% interest on the invested funds. At the end of the 10-year period (otherwise referred to as the bond maturity date), you'll get the initial investment back.
However, there's a risk that the issuer could default, meaning that they can't pay back the debt, so the investor could end up losing what they paid for the bond. Thus, the higher the risk of default, the higher the interest rate tends to be to compensate investors for this risk.
Bonds and the economy
While often considered a low-risk investment, bonds are still influenced by market and economic conditions.
"They trade in the public markets just like stocks, and have their values fluctuate based on two key variables: inflation and interest rates," says Jarah D. Macfarlane, an accredited portfolio management advisor and founder of Macfarlane Investors.
Inflation and rising interest rates erode the purchasing power of fixed-income investments like bonds. As interest rates rise, fixed interest payments decrease in value, reducing bondholders' overall return. As a result, existing bonds become less attractive to investors, lowering bond prices.
The best way to reduce the impact of inflation and fluctuating interest rates on bonds is through diversifying your portfolio with other asset classes. You could also consider:
- Buying Treasury Inflation-Protected Securities (TIPS), whose principal values adjust based on inflation
- Investing in bonds with shorter durations to decrease interest rate fluctuations
When interest rates are cut, bonds become more attractive, and prices increase.
Types of bonds
There are four main categories of bonds: government (federal), corporate, municipal, and agency.
Government bonds
Technically, government bonds are any type of bond issued by a government. Still, in the US, a government bond usually refers to those issued by the U.S. Treasury to raise funds for the federal government. These securities are known as Treasuries, with names indicating different maturity periods.
- T-bills: Matures between four weeks and 52 weeks
- T-notes: Matures between two to 10 years
- T-bonds: Matures between 20 and 30 years
Treasuries are typically regarded as one of the safest investments available, as they have the federal government's backing. The government is generally more stable and able to pay its debt than, say, a corporation that runs the risk of bankruptcy.
Interest earned from Treasuries is generally exempt from state and local taxes.
Corporate bonds
Issued by individual companies, corporate bonds raise funds to expand the company's operations.
The interest earned from corporate bonds is taxable at the federal and state/local levels, but many corporate bonds offer higher returns than government or municipal bonds. That's because corporate bonds often have a higher risk of default, although you can view the grades of different bonds to get a better idea of how much risk experts think there is.
Municipal bonds
Also known as "munis," municipal bonds are issued by state and local governments to build roads and schools and fund other projects.
You can use a handful of beneficial tax strategies when investing in municipal bonds to minimize your tax bill.You won't pay tax on interest payments at the federal level, and if you're a resident of the state where the bonds are issued, you can often avoid state and local income tax.
However, interest rates on municipal bonds are usually lower than rates for Treasuries. High-yield municipal bonds offer potentially higher returns, but there's an increased credit risk. There are also taxable municipal bonds, which also provide a higher return.
Agency bonds
What separates agency bonds from what are traditionally known as government bonds is the issuer. Agency bonds are issued by any government department other than the US Treasury. Examples could include the Small Business Administration or the Federal Housing Administration.
Some agency bonds pay higher interest rates but do not have the tax benefits compared to Treasuries and muni bonds.
Benefits of investing in bonds
Bonds provide various benefits, depending on the type and the investor's goals. In general, though, some common benefits of investing in bonds include:
- Diversification: Rather than investing solely in stocks, adding bonds to your portfolio helps diversify your allocation so all your eggs aren't in one basket. Although bonds are generally less profitable than high-earning stocks, they are low-risk. Diversifying your portfolio across various stocks and bonds mitigates overall risk, preventing major losses.
- Reduced volatility: Related to diversification, bonds can often reduce the volatility of a portfolio. If stocks decline, for example, bonds might increase or at least not fall quite as much. And if you hold a bond until maturity and the issuer doesn't default, then you don't have to worry about temporary dips in value.
- Predictable income: As the name fixed income suggests, bonds can provide regular, predictable income. That can make these assets great for situations like retirement, where you want a reliable income stream rather than worrying about the stock market going up or down.
- Tax benefits: Some bonds provide tax benefits, such as interest on Treasuries not being taxed at the state and local level and interest on some muni bonds being completely tax-free.
Risks of investing in bonds
While bonds can often reduce portfolio risk, there are still risks to watch out for, such as:
- Defaults: If a company or government goes bankrupt, it might not be able to repay its debts, including to bondholders so that you could lose part or all of your investment. Different bonds have different assumed risks of default, such as junk bonds having a high risk and Treasuries having a low risk.
- Inflation: While some bonds provide inflation protection, such as Treasury Inflation-Protected Securities (TIPS), others could risk losing value due to inflation. For example, buying a 10-year bond at a 2% interest rate and inflation averages 3% over those 10 years would effectively lose money.
- Interest-rate changes: Many bonds can be traded before maturity, but that could mean that the value of your investment is at risk due to interest-rate changes. Typically, if interest rates increase, then the value of a bond decreases because investors would not want to pay as much for a bond with a lower interest rate than bonds currently being issued.
- Opportunity cost:There can also be anopportunity cost to investing in bonds. If you're too conservative with your investments, such as putting most of your retirement funds in bonds while in your 20s, you could missout on significant stock market gains, thereby leaving you with less money in retirement.
How to buy bonds
There are three primary ways for individuals to buy bonds: through your brokerage account, direct from the U.S. Treasury, or indirectly through a mutual fund or ETF. Even if you're not an experienced investor, it doesn't have to be a complicated buying process. Here, we'll walk through how to buy bonds for beginners.
Through a brokerage
The first step to buying a bond through your brokerage is to check and see if it offers individual bonds. As the next section explores, Some offer new issues and secondary market offerings, while some only offer access via bond funds.
After selecting a brokerage where bonds are available and logging into your account, navigate to the products or trading menu. In most cases, you will find an option for bonds and CDs. If not, you may find a bond option under the fixed-income section.
Depending on your brokerage, you may be presented with a grid with bonds organized by type (government, corporate, etc.) along with their interest rates and maturities.
Select the category you're interested in to find a list of bonds, and select the buy button. If you use a financial advisor or broker, they might also have access to bonds, and you can instruct them to place an order for you.
Through the secondary market
Bonds can be bought and sold before maturity in the secondary market. In this market, investors trade with one another rather than buying new bonds.
Perhaps you bought bonds when interest rates were higher than they are now, so by selling before maturity, you might be able to make a profit, as an investor might pay a higher price for a bond that pays, say, 4% rather than buying a new issue at 3.5%.
Through a mutual fund or ETF
Buying bonds through a mutual fund or ETF is one of the most common and simplest ways to add bond exposure to your portfolio. Some funds specialize in trading a basket of bond securities, such as long-term Treasuries or highly rated corporate bonds, and rather than picking individual bonds yourself, you can leave that to the fund manager.
The process is similar to buying a stock, as bond funds' trading prices constantly fluctuate, and you can typically buy and sell them during stock market trading hours.
To trade bond funds through your brokerage account, navigate to the trading menu and enter the ticker symbol of the fund you're looking to invest in, or you might be able to search by name. After you select the fund you're looking for, your brokerage should display the fund's share price, just like for stocks. From there, you can execute the trade to buy as many shares as you desire.
Directly from the government
To buy bonds online issued by the U.S. Treasury, your first step is to register for an account at TreasuryDirect.gov. From there, navigate to the "Buy Direct" tab.
You will be presented with several options. Select the type of bond you want to buy and submit the purchase.
Note: You can buy most government bonds, including treasuries through your brokerage, however I-Bonds can only be purchased through Treasury Direct.
Through a payroll savings plan
A payroll savings plan is an account offered by TreasuryDirect that allows workers to contribute a portion of their paychecks to the account to purchase electronic savings bonds. There are two types of savings bonds: EE bonds and I bonds.
Accumulated interest is kept in your TreasuryDirect account until you decide to cash out or until it reaches its 30-year maturity.
How to buy bonds as a gift
According to Alexander Voigt, founder and CEO of Daytradingz.com, anyone with a TreasuryDirect account can gift savings bonds if the person to whom they're gifting the bonds also has a TreasuryDirect account.
You'll need at least $25 to buy an electronic savings bond, and you can buy one for as much as $10,000. However, if you're looking to gift bonds to someone under 18 (or their state's age of majority), that person's parents must set up a minor-linked account with their TreasuryDirect account, according to Voigt. You'll also only be able to gift bonds in electronic form.
Investors can currently only purchase EE or I savings bonds directly from the U.S. government, and, as mentioned earlier, you'll need a TreasuryDirect account to do so.
"You need to buy the gift savings bonds first on your behalf with your account and hold it for a minimum of five business days before you can deliver them as a gift," Voigt explains. He adds that entering the gift recipient's Social Security number and name is required during the purchasing process, but it's crucial to click on the box that specifies "This Is A Gift" when buying the bonds.
How to gift bonds to charity
You aren't limited to individuals when it comes to gifting bonds. You can also gift bonds to charities, but as with individuals, the charity must establish a TreasuryDirect account for you to gift the bond. The platform offers accounts for the following types of entities:
- Limited liability companies (LLCs)
- Corporations
- Partnerships
- Sole proprietorships
- Trusts
- Professional limited liability companies (PLLCs)
- Living estates
- Deceased estates
To fulfill the transfer, you'll also generally need the charity's name, account information, and the details of the bond you're gifting.
"The buyer of the gift savings bond sees the bonds generally issued to the 'Gift Box' in their TreasuryDirect account within one business day," Voigt says. In the final step, he adds, the buyer of the gift savings bond has to go into their Gift Box to select the bond they want to deliver, enter the recipient's TreasuryDirect account number, and submit the request.
Strategies for bond investing
If you decide to invest in bonds, there are several strategies you can deploy to try to optimize returns or fit your risk profile. Some common bond investment strategies include:
Laddering
Like with CDs, you can create a bond ladder by buying bonds at different maturities for a continuous liquidity stream.
For example, if you buy 1-year, 2-year, and 3-year Treasuries, you would have one and two years left on the other bonds by the time the 1-year bill matures. So, with the money you get from the 1-year T-bill maturing, you could buy a 3-year T-note.
Barbell strategy
Another strategy is to buy only short—and long-term bonds, not intermediate ones, so that your maturity dates look like a barbell, weighted on each end.
This approach could be helpful if you want to balance short vs. long-term risks. For example, you could have some near-term liquidity and the security of a fixed long-term rate. At the same time, long-term bonds generally have more interest-rate and inflation risk, as there's more time for conditions to change.
Buy and hold
One way to reduce the risk of fluctuating bond prices is to take a buy-and-hold approach. You will hold the bond until maturity rather than trade it like a stock.
Some buy-and-hold investors deploy a bullet strategy, meaning they buy bonds at different intervals, all with the same maturity date. For example, if you know you'll have to start paying for your child's college education in five years, perhaps you'd buy a five-year bond now, a four-year bond next year, etc.
That way, they all mature in five years, and meanwhile you can reduce interest-rate risk. If you only bought five-year bonds now, you could miss out on potentially higher returns if interest rates increase next year, for example.
How to evaluate bond investments
Before purchasing, evaluate bond investments to ensure they're a good option for you.
How to assess bonds
There are multiple factors to consider when assessing bonds, including:
- Price: Bonds trade at a premium, discount, or par. A bond trading at a premium to its face value (amount redeemed at maturity) means that the bond is trading at a higher rate. A bond trading at a discount rate means the price is lower than its face value and generates lower yields. A bond with a price at par means it is trading at its face value.
- Interest rate: Interest rates for bonds can be fixed or floating. Most bonds have fixed rates, meaning the applied rate does not change. On the other hand, a floating rate changes based on a benchmark. A floating rate can help combat inflation and rising rates but leaves investors vulnerable to market fluctuations.
- Date of maturity: When buying bonds, consider the date of maturity. Bond maturities can range from one year to as long as 30 years. The longer the duration of your bond, the greater its susceptibility to interest rate and inflation risk. Short-term bonds are less vulnerable to interest rate changes but have less time to accumulate interest.
- Redemption: Another factor to consider is how flexible it is to redeem a bond before it reaches maturity, especially if you're looking at bonds with long-term maturities. You may be able to set a put provision to redeem the bond at a specific price on a date prior to the maturity date.
Bond ratings and creditworthiness
Three main credit rating agencies in the US determine a bond's interest rate and potential risk based on the likelihood that the bond issuer (company or government) defaults on its debt obligation.
A bond considered "investment grade" has a relatively low risk of defaulting. Agencies periodically reevaluate bonds and release this information to newspapers for publication. Depending on the grades, bond issuers adjust the price of their bonds.
The three bond agencies are:
- S&P Global Rating: The rating ranges from AAA (highest rating) to D (lowest rating). A bond that falls to BB+ status is considered no longer investment grade. A D rating means the bond defaults, and the issuer is not financially stable.
- Fitch Ratings: Ratings are similar to the S&P Global Rating, with AAA being the highest and D being the lowest. Fitch considers factors such as debt type and susceptibility to systemic changes alongside the standard considerations.
- Moody's: Ratings are determined by analyzing quantitative and qualitative factors to determine the chance of default. They use both letter grades and numbers. The highest rating is Aaa, with the lowest rating being C. Bonds with ratings Caa1, Caa2, Caa3, and Ca are at higher risk of default.
Bond rating agencies use a range of methodologies and financial indicators to determine the creditworthiness of a bond issuer. This includes examining macroeconomic elements — interest rates, inflation, political stability — and financial information — debt ratios, cash flow, liquidity, and financial statements.
Bond FAQs
What is the minimum amount needed to buy bonds?
The minimum amount needed to buy bonds depends on the type of bond and issuer. Some bond funds have no minimums, while government savings bonds start at $25, and other Treasuries have $100 minimums. Buying corporate bonds directly often involves higher minimums, such as $1,000 or more.
Are bonds a safe investment?
While bonds are typically considered a safe investment, all investments carry risk. The degree of risk with bonds depends on the type of bond and issuer, such as how a Treasury security is often considered very safe. In contrast, a corporate bond from a highly indebted company could be risky. There's also risk beyond the risk of losing money — interest rate risk, for example, could mean suffering an opportunity cost if interest rates rise after you buy bonds.
Can I sell bonds before they mature?
Typically, you can sell bonds before they mature, but it depends on the specific bond. Many bonds have robust secondary markets, meaning you can buy and sell them after they've been issued and before their maturity dates. However, selling before maturity could mean suffering losses, depending on the market.