Bonds are an important part of most investment portfolios. Because bond prices aren’t known for the high level of volatility seen in the stock market, these fixed-income investments have become a staple in safe-haven allocation.
Not all bonds are created equal, and like investing in stocks, bond investing comes with its own risks. Before investing in bonds, it’s important that you understand the risks and the steps you should take to ensure you meet your investment objectives.
Here’s a guide to help you begin investing in bonds.
How to Invest in Bonds
The bond market provides both a hedge against stock market volatility and a source of income. However, like any investment vehicle, how big of a hedge and how much income largely depends on how you go about investing in bonds.
1. Learn the Basics
The first thing you’ll need to do is learn the basics of bonds.
A bond is a form of debt. The issuer of the bond is the borrower, while the investor acts as the lender. When a new bond is issued, it comes with an interest rate, known in the investing world as a coupon. Interest payments, or coupon payments, are generally made on a quarterly basis.
Bonds also come with maturity dates. These are the dates at which the face value of the bond will be paid back to the investor by the issuer.
Short-term bonds mature within three years and have the lowest bond yields. Mid-term bonds come with maturities ranging from three to 10 years and offer mid-level coupon rates. Finally, long-term bonds generally come with the highest returns and mature in 10 years or longer.
Bonds of different types also come with their own types of risk. Some bond issuers have a greater credit risk or default risk. And most bonds are subject to inflation risk and interest rate risk depending on the state of the broader economy.
Types of Bonds
There are multiple types of bonds available on the bond market, with the issuer of the bonds being the distinction between the different types. Those types include:
U.S. Treasury Bonds
Treasury bonds are bonds issued by the U.S. Treasury. These debts are backed by the full faith and credit of the U.S. government, making them some of the lowest risk investments that can be made.
Because there are minimal risks associated with investing in Treasury bonds, the coupon rate paid on these investments is generally lower than other options. However, earnings on these bonds are not subject to state and local income taxes, though federal income tax still applies.
Municipal bonds, also commonly referred to as munis, are also government bonds, but slightly different. The bond issuer on munis is a municipal government agency. These agencies issue bonds to cover the costs of projects and balance their budgets.
While these bonds aren’t as safe as Treasury bonds, they’re next on the list. This means they pay a higher rate than Treasury bonds, yet provide lower returns than corporate bonds.
As the name suggests, corporate bonds are bonds issued by corporations. These bonds generally pay higher interest rates than government-issued bonds like Treasuries and Munis, but the exact rate you’ll be paid is largely determined by the maturity date and credit quality of the issuing company.
High-Yield Junk Bonds
Finally, junk bonds offer higher yields than investment-grade bonds, but don’t let them fool you — there’s “junk” in the name for a reason. Junk bonds are issued by companies that have relatively low credit ratings. These bonds are at a high risk of default or other credit-related event, increasing the risk of the investment.
2. Choose an Investment Strategy
Now that you know a thing or two about bonds, it’s time to choose an investment strategy. Your strategy dictates the types of bonds you’ll be investing in based on your risk tolerance and your investment goals.
- Your Risk Tolerance. Everyone has a different level of comfort with risk. Your strategy should only be centered around investing in bonds that match your risk tolerance.
- Your Investment Objectives. Your goals are important and should be considered when determining your investment strategy. If your goal is to generate higher levels of income in a shorter period of time, you may end up with a strategy centered around junk bonds. On the other hand, if your goal is to bring the highest level of stability to your portfolio, Treasury bonds may be your prime investment.
You should also decide whether you want to choose bonds to buy for yourself or entrust the selection to somebody else. Your strategy can involve:
- Individual Bond Investments. You can choose to take the active role and invest in individual bonds on your own. Making individual bond investments gives you complete control over your portfolio. Of course, if this is the path you choose, you’ll be required to research the bonds you’re interested in and choose bonds that will perform well.
- Bond Funds. You can also take the mutual fund and exchange-traded fund (ETF) approach to investing in bonds. With these funds, you simply contribute money to the funds and the fund manager makes all the hard investment decisions for you.
- Robo-Advisor. For a completely hands-off approach, follow the lowest effort strategy of investing with the help of a robo-advisor. Robo-advisors make all the hard decisions for you, and most can even be set for automatic contributions so you don’t even have to remember to invest.
3. Determine Asset Allocation
Asset allocation is crucial in the world of investing. In most situations, not all your investment dollars should be allocated to bonds. The only time this might be prudent is if you’re an extremely risk-averse investor with a relatively short time horizon.
For most investors, a mix of stocks and bonds is best. Stocks allow you to access reasonable returns while bonds provide a hedge against stock market volatility.
If you’re not sure how much of your investment portfolio should be allocated to bonds, use your age as a starting point.
For example, if you’re 25 years old, start by investing 25% of your investment dollars in bonds and 75% in stocks. If you’re 52 years old, put 52% of your investment dollars in bonds and 48% in stocks.
Once you’ve built your portfolio, consider the performance over time and tweak your asset allocation to fit your risk tolerance and investment objectives.
4. Open an Investment Account
Before you can buy bonds, you’ll need a brokerage account. Your broker will act as the middleman, providing you access to a diversified group of options. However, brokers are private companies that have the right to charge what they see fit for their services.
As a result, every broker is different and the quality and price of the services you receive will largely depend on the broker you choose to work with.
Do your research to determine which broker will be best for you. Pay close attention to whether the broker offers bonds and other assets you want to invest in, the fees you’ll pay, and consumer reviews.
You can also purchase U.S. Treasury bonds directly from the U.S. government at TreasuryDirect.gov. This lets you avoid paying middleman fees to a brokerage.
5. Choose Your Bonds
Next, it’s time to choose and buy your bonds. When buying bonds, there are a few factors to keep in mind:
- Time Horizon. While long-term bonds offer the highest returns, they’re also the riskiest plays. The best time to buy a long-term bond is when interest rates are high and you believe rates will soon fall. By purchasing long-term, you’ll be able to lock in the higher rates. Stick to short-term offerings when interest rates are low. You don’t want to get locked into minimal coupon payments.
- Issuer. Jumping into Treasury bonds may be appealing because they’re backed by the full faith and credit of the U.S. government, but their returns often leave much to be desired. Consider the credit rating of the issuer of the bonds you buy and how that will affect your returns.
- Diversification. If you’re like most, buying 100% short term or long term, and 100% corporate or Treasury bonds, just isn’t going to be a good fit. That’s because short term and long term bonds offer different returns and are best for different interest rate environments. Moreover, government bonds don’t tend to pay as well as corporate bonds. To get the best of all worlds, diversification is a must.
Bonds can be purchased through your broker or the U.S. Treasury through the Treasury Direct website. When buying bonds on Treasury Direct, you’ll be asked to complete a simple application process.
You’ll be prompted to select the type of bond you’d like to purchase, source of funds you’ll be purchasing it with, the owner of the bond (yourself or a gift recipient), and a purchase schedule (one time or recurring).
Next, submit your order and your bonds will appear in your account within two business days.
6. Monitor and Rebalance Your Portfolio
Investors should always keep close tabs on their investment portfolios. You don’t necessarily have to dive into your bond portfolio daily or weekly, but it is a good idea to check in on it on a quarterly basis or so.
If you find that some bonds in your portfolio aren’t performing to your expectations, do a bit of research to find out why.
In some cases, the lull may be short-term and a recovery likely. In other cases, the decline could be due to a reduced credit rating or financial struggles of the bond issuer, in which case it may be best to sell the bond on the secondary market and look for other opportunities.
As you review your portfolio, you’ll find some assets will move at different rates and in different directions than others. Usually bonds experience less dramatic price movements, so it’s likely that other assets in your portfolio (such as stocks) will grow faster during bull markets or shrink more during bear markets.
Over time, this will lead to an imbalance in your portfolio that will either leave you overexposed to risk or underexposed to returns. As a result, you’ll need to rebalance your portfolio on a regular basis.
If you find that your asset allocation has fallen out of balance, simply sell some of the overallocated assets and purchase more of the underallocated assets to bring your portfolio back to where you want it.
Bonds are an important part of just about every investment portfolio, providing stability to protect you against market volatility. However, when investing in bonds, it’s important that you choose your investment wisely.
Low quality bonds provide little protection, while the highest quality bonds will provide only modest rewards. Do your research and find a balance that you believe will work best for your portfolio.