How to Invest in Bonds: A Comprehensive Guide
The better you understand bonds—a unique investment opportunity—with respect to how they work, different types, and related pros and cons, the more effectively you can use them. Whether you're a fledgling investor or in fact quite seasoned and seeking to refine your strategy, here’s what you need to know.
What are bonds?
When you invest in bonds, you're essentially acting as a lender by allowing an entity such as a government, corporation, or municipality to “borrow” your money in exchange for a specific interest payment and eventual repayment of the loan.
Interest rates (AKA annual returns) vary depending on the specific bond, but historically (based on the last 20 years), government 10-year treasury bonds have annual returns between 3% and 4%.
In contrast, the stock market—as measured by the S&P 500—has seen historical average annual returns of over 10% since1957, per Investopedia. If bonds come with lower returns, then, why should one invest in them? Because they’re less risky than stocks. Let’s consider how they work to see why…
How bonds work
Let’s say a corporation wants to expand into a new market but lacks the capital necessary to do so. Bank loans are of course one option in this case, but these might come with additional rules (such as restrictions regarding additional debt) as well as high interest rates. Another—and perhaps better—option is to issue a bond, essentially borrowing money from investors at a cheaper interest rate while saving the company money and enjoying fewer restrictions.
It’s not just the corporation that benefits in this case, however, as investors gain access to an investment with less risk than stocks. Why? Because it’s more difficult to lose your principal investment in a bond than with an investment in the stock market. For example, you could invest $100 in stocks only to see the price drop 20% the next day—leaving you with $80. With a bond, the company (or other entity) promises to repay your loan, with interest tacked on as well.
Even if said company goes bankrupt, bondholders are second in line for repayment (after senior debt, such as loans from banks) whereas common equity (i.e., company stock) has the lowest repayment priority. This isn’t to say it’s impossible to lose your principal in a bond investment or that bonds don’t come with other risks; the nature of how they function, however, makes them comparatively safer than more volatile investment vehicles such as stocks.
Types of bonds
Bonds are not created equal. The bond market is in fact a varied landscape offering a range of options tailored to diverse investor preferences. Here's a glimpse at the most common types.
Government bonds
Government bonds, also known as sovereign bonds, are stalwarts of stability. Backed by the national government (and issued by the U.S. Department of the Treasury), these are synonymous with low-risk investments and serve as a cornerstone for risk-averse investors. The assurance of timely interest payments and return of principal make government bonds a reliable choice, especially when volatile market conditions are at play.
Four types of government bonds each have varying maturation periods: Treasury bills (often a few weeks up to a year), Treasury notes (two to 10 years), Treasury bonds (10+ years), and Treasury Inflation-Protected Securities (five, 10, and 30-year periods).
Savings bonds
The government also issues two types of U.S. savings bonds. The first, EE bonds, are guaranteed to double in value in 20 years. The second, I bonds, serve as protection against inflation—with inflation-based interest rate adjustments made every six months. Unlike other types of bonds, savings bonds cannot be sold on a secondary market.
Corporate bonds
Issued by companies seeking capital, corporate bonds offer investors a chance to participate in the success of private enterprises. The level of risk associated with corporate bonds depends on the financial health and creditworthiness of the issuing company. Corporate bonds fall into one of two categories: investment grade bonds or high-yield bonds (also known as “junk” bonds).
While the former come from companies boasting at least a BBB credit rating from a credit-rating agency (and feature lower yields but also less risk), the latter produce higher yields—but as their nickname implies, they often have low credit ratings and therefore more risk.
Municipal bonds
Municipal bonds give investors an opportunity to align their financial interests with the betterment of local communities. Issued by city or state governments, these bonds finance crucial public projects such as infrastructure development, schools, and hospitals. Beyond their social impact, municipal bonds often summon tax advantages: making them an attractive proposition for investors looking to optimize their tax liabilities.
Key terms to know
Understanding the language involving bonds is crucial to make informed investment decisions. Here are a few essential terms:
Coupon rate
The coupon rate is the amount of interest paid to bondholders and typically refers to the annual interest rate.
Yield
The yield is the percentage return on your investment, combining interest payments and potential capital gains. When you first purchase a bond, the yield to maturity and coupon rate are the same. The price of the bond may change due to investor demand, however, causing the yield to maturity to also fluctuate.
Maturity
Maturity is essentially the lifespan of the bond, indicating when the principal will be repaid. Bonds that mature in one to three years are typically considered short-term, four to ten years medium-term, and more than ten years long-term.
Secured/unsecured
A bond is either secured or unsecured. While the former features an asset that serves as collateral (e.g., a mortgage-backed security whereby the title to the borrower’s home does this), the latter does not. Unsecured bonds are considered much riskier than secured bonds.
Interest rates and bonds
Understanding the association between interest rates and bonds is crucial. At its core, this relationship is inverse; when interest rates rise, bond prices tend to fall (and vice versa). This fundamental principle is rooted in the concept that existing bonds with fixed interest rates become less attractive in a higher-rate environment.
Imagine you hold a bond with a fixed interest rate of 3% in a low-interest-rate environment. If market interest rates rise to 4%, new bonds will be issued with higher yields—making your 3% bond less appealing to potential investors. As a result, the market value of your existing bond may decrease to align with the new, higher-yielding options. Conversely, if interest rates fall, your fixed-rate bond becomes more attractive because it offers a higher return than new bonds issued at lower rates. This increased demand can drive up the market value of your existing bond.
Rising interest rates are often a double-edged sword for income-focused investors relying on regular interest payments from bonds. While new bonds may offer higher yields, existing bonds may lose market value: impacting income generated from one’s portfolio.
Pros and cons of investing in bonds
As with any investment, bonds come preloaded with both pros and cons.
One of the biggest advantages of bonds is that they’re generally less volatile than stocks, adding stability to a portfolio alongside the potential for returns (as opposed to keeping your money in cash). They also provide regular income, thanks to consistent interest payments. Finally, bonds offer diversification to counterbalance other investments.
Bonds also have their drawbacks, however. Though stable, they often yield lower returns compared to riskier assets such as stocks. There’s also the risk posed by tying an asset so closely to interest rates, as the value of existing bonds is often negatively impacted by rising rates. Last but certainly not least, fixed-interest payments may lose purchasing power over time due to inflation.
How bonds fit into your portfolio
Overall, we’ve seen how bonds offer a nice middle ground between stocks and cash with respect to risk and potential reward. The question thus becomes: what can be done with this information? Bond strategies vary dramatically depending on the investor, so let’s consider two hypothetical examples to see what this means…
Our first investor is 30 years old and has no major expenses planned. While bonds provide a nice level of diversification, she can handle more risk and therefore may decide to invest in a portfolio of 70% stocks and 30% bonds. Our second investor, meanwhile, is seventy years old, retired, and living on a fixed income. His tolerance for risk is low, so he invests in a portfolio of 30% stocks and 70% bonds.
Both investors take advantage of the diversification offered by bonds, but since each is unique, the “right” proportion varies.
The key takeaway
Now armed with a deeper understanding of bond investments, you're poised to make more informed decisions as you continue on your financial journey. Whether you’re seeking stability, consistent income, or diversification, bonds give you a multifaceted toolkit to rely on. Remember that this learning is an ongoing process, however, so be sure to stay curious, stay informed, and reach out to a financial professional for more personalized advice.
Still have questions about bonds and how they fit into your overall investment strategy? Schedule a FREE Discovery call with one of our financial advisors today.
FAQs
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Junk bonds are best suited for investors who are willing to take on significant risk as they offer more potential for higher returns than investment-grade bonds.
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Savings bonds are often a wise choice for investors seeking a safe investment (guaranteed by the federal government, which has never defaulted on its debt) and those looking to reduce risk in their investment portfolio. Series I bonds are also a good investment during periods of high inflation as their interest rate adjusts every six months based on current inflation readings: ensuring your money won’t lose purchasing power.
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Treasury bonds are generally a good investment, but whether or not you should add them to your investment portfolio really depends on your own individual goals and risk tolerance. These are often used to reduce risk in your portfolio (especially if your investments are primarily in stocks) and to generate income (via interest payments).
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk
