Bonds have long been considered an essential component of a diversified investment portfolio. While they may not be as flashy as other asset classes, bonds still have a role to play because they can help provide stability and income, balancing out the volatility and growth in stocks.
What are bonds?
A bond is essentially a loan an investor (the bondholder) makes to a borrower (the bond issuer), which is typically a government or corporate entity. For this reason, bonds are also sometimes known as debt instruments or debt securities. The bondholder is paid interest for this loan.
Before we get into the specifics of how they work, it’s important to understand a few key terms:
- Face Value: Face value is the price of the bond when it is issued. It is the amount of money that the bondholder is guaranteed to receive if the bond is held to maturity (so long as the bond issuer does not default). Face value is also known as par value or the issue price.
- Coupon Rate: The coupon rate communicates how much income a bond generates for the bondholder, typically expressed as an annual rate. It is also known as the bond’s interest rate.
- Maturity Date: This is the date at which the bondholder can “cash it in” in exchange for the bond’s face value.
- Coupon Date: This is the specific date on which a bondholder will receive an interest payment for holding a bond.
- Term: A bond’s term is the number of years it will take to reach maturity from issue date. A company or government entity can issue short-, medium- or long-term bonds.
How Bonds work
When an investor buys a bond, they typically pay the bond’s face value directly to the issuer. In exchange, they receive periodic interest payments, according to the bond’s coupon rate and payment schedule, making it an excellent source of income. When the bond reaches maturity, the bondholder redeems the bond, and receives the bond’s face value from the bond issuer.
Alternatively, bonds can also be purchased and sold at a secondary bond market. In the event a bondholder may decide not to hold a bond all the way to maturity the bondholder may sell the bond on the secondary market, much like how an investor would sell a stock they no longer need or want.
It should be noted that certain bonds are known as redeemable or callable. This means it can be paid off early if the issuer chooses to do so. While the bondholder will receive the bond’s face value if their bond is called, they may forgo previously expected interest. Bonds do not always have to be purchased at face value – they can be purchased at a premium or discount.
How to invest in bonds
If you’re interested in investing in bonds, you have several options. You can, for example, buy bonds directly from the bond issuer. Alternatively, you can purchase bonds through a brokerage much like you would stocks.
Additionally, you can either purchase individual bonds or shares of bond funds. We take a closer look below.
If you are interested in purchasing individual bonds, you must weigh each bond’s yield against the potential risks. High-yield bonds are typically deemed higher risk; otherwise, the issuer would be able to secure financing at lower interest rates.
Additionally, just as you would diversify your stock portfolio, it’s essential to diversify your bond portfolio. You might, for example, hold corporate bonds from different companies operating in different industries. Likewise, you might hold several types of bonds (corporate, government and municipal) in order to spread your risk. In addition you might look for bonds with varying terms to help protect you from fluctuations in interest rates. Your ideal allocation will depend on your unique financial situation and goals.
A bond fund is a type of mutual fund or exchange-traded fund (ETF) that invests in bonds, offering investors a means of quickly diversifying their bond investments without needing to construct a bond portfolio from scratch.
Some bond funds will invest exclusively in a particular type of bond, such as a corporate bond fund investing solely in corporate bonds, a government bond fund investing solely in government-issued bonds, etc. Other funds may take a more diversified approach, investing in multiple types of bonds carrying different terms.
As with evaluating individual bonds, it’s important to consider your own goals and risk tolerance when selecting one or multiple bond funds to invest in.
Common types of bonds to invest in
Bonds come in a variety of flavors. The main types you should be aware of include corporate, municipal, government and agency bonds. We explore each of these below.
When a business needs to raise money, say, to fund an acquisition or project, it may issue corporate bonds to do so. Corporate bonds are generally considered riskier than a government bond, and as such, will usually offer higher interest payments to make up for the increased risk.
The risk of different corporate bonds can vary widely and is tied to the financial health of the company issuing the bond. Bonds issued by established, profitable companies with a track record of meeting their debt obligations are typically considered to be less risky compared to those issued by younger, less profitable companies with shorter (or nonexistent) credit histories.
It’s important to note that if a business were to fall into default, bondholders are typically compensated prior to shareholders.
Municipal bonds are bonds issued by cities, counties, states and other government entities, usually to finance specific projects — such as building a bridge, refurbishing a school, upgrading a sewer system, etc.
Municipal bonds are considered less risky than corporate bonds, but carry a little more risk than bonds issued by the federal government.
Municipal bonds also typically receive favorable tax treatment, which can be a key reason to use them. Interest earned on municipal bonds is often (though not always) free of federal income tax and may also be free from state or city income taxes for residents of those municipalities.
In most cases, when someone is talking about government bonds, they are talking about a variety of debt instruments known as Treasurys. These include:
- Treasury Bills: Treasury bills are a form of short-term debt with a maturity up to one year.
- Treasury Notes: Treasury notes mature in either two, three, five, seven or 10 years.
- Treasury Bonds: Treasury bonds mature in 20 or 30 years.
- TIPS: TIPS, or Treasury Inflation-Protected Securities, earn a variable interest rate that floats depending on the underlying rate of inflation each year. They mature in either five, 10 or 30 years.
- I-Bonds: I-bonds are savings bonds linked to inflation, like TIPS.
U.S. Treasurys are considered the least risky of all bonds because they carry the backing of the United States government, which has never defaulted on its obligations. This lower risk means that U.S. Treasury bonds will typically offer a lower yield compared to corporate, municipal and agency bonds.
Bonds issued by national governments besides the United States are typically called sovereign debt.
Agency bonds are a specific type of bond issued by a federal government agency and not the U.S. Treasury.
These bonds are less liquid than Treasury-issued bonds, and as a result, typically carry a higher interest rate. But because they are still backed by the U.S. government, they are considered less risky than municipal and corporate bonds and tend to carry lower interest rates than those do.
Importantly, bonds can also be issued by government-sponsored enterprises (GSE), like Fannie Mae and Freddie Mac. While these enterprises are supported by the federal government and subject to federal oversight, they are, in fact, private companies. For this reason, bonds issued by GSEs, which are sometimes called agency bonds, do not carry the same level of backing by the U.S. Treasury, which translates into higher risk (and usually higher yields) than true agency bonds.
Who should consider investing in bonds?
Bonds, especially Treasurys, are often considered to be investments with the lowest risk that are available because there is a low chance that you will lose your capital. This risk increases for corporate bonds, but even then, is considered lower than the risk you might expect from stocks, real estate and commodities.
Bonds can make an excellent investment choice for more conservative investors and those with low risk tolerance.
The regular interest payments can also make them an excellent source of income generation in an investment portfolio. Bonds, therefore, can become an essential part of the financial picture for any investor looking to generate income, such as retirees.
Likewise, because the bond market tends not to move in lockstep with the stock market (and other assets), allocating a certain percentage of your portfolio to bonds is a solid means of diversifying.
However, while they tend to be more stable, bonds typically won’t offer the potential upside that you can get from owning stock in companies. That’s why many investors use a mix of both stocks and bonds.
Which bonds are best for you?
In selecting bond investments, it’s important to consider your risk tolerance, investment timeline and financial goals. For more conservative investors, Treasurys may be the best choice. For those who accept higher risks, corporates may be the answer, with other options for those in between.
If you are unsure about which bonds you should include in your investment portfolio, a financial advisor can help. In addition to evaluating individual bond opportunities, a financial advisor will also help you keep your broader financial picture in mind to ensure that all other aspects of your portfolio and financial plan are working as they should be.
All investments carry some level of risk, including the potential loss of principal invested. You should carefully consider risks with fixed income securities such as bonds, these include: Interest rate, Duration, Credit, Default, Liquidity and Inflation. Interest rates and bond prices tend to move in opposite directions, for example when interest rates fall, bond prices typically rise. This also holds true for bond mutual funds. A low interest rate environment may cause losses to bond prices and bond funds you own or in the market. Interest rates in the United States are at, or near historic lows, which may increase a Fund’s exposure to risks associated with rising rates. High yield (Junk) bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds.