If you’re looking to diversify your investment portfolio, you might want to consider investing in bonds. Not only do they provide a steady stream of income, but they also come with less risk than stocks. With the right approach, you could get a similar yield to that of a certificate of deposit (CD) or savings account (and maybe even more!).
But how do you go about buying bonds? Don’t worry, we’ve got you covered! We’ll go over some useful bond-buying strategies to help you make informed investment decisions.
Of course, like any investment, there are pros and cons to investing in bonds. We’ll discuss these in detail so you can decide whether bonds are the right investment for you.
So, whether you’re a seasoned investor looking to diversify your portfolio or a beginner just starting out, this guide will provide you with all the information you need to start investing in bonds. Let’s get started!
Table of Contents
What are bonds and how do they work?
A bond is essentially a loan that a company or government issues in order to raise money. When you buy a bond, you’re essentially lending money to that entity. In return, they promise to pay you back with interest over a set period of time.
Bonds are often referred to as fixed-income securities because they pay a fixed rate of return. The rate is determined at the time of purchase and remains the same throughout the life of the bond. Interest is typically paid to investors on a regular basis, whether monthly, quarterly, semiannually, or annually, depending on the bond.
Many people prefer to invest in bonds because they tend to be less volatile than stocks, making them a safer investment option. However, it’s important to note that not all bonds are created equal. Different bonds have different levels of risk and reward, so it’s important to do your research before investing.
When it comes to building your bond portfolio, there are several strategies you can use to make sure you’re investing in the right bonds for your needs. Some investors prefer to focus on bonds with shorter maturities, while others prefer to diversify their bond holdings across a variety of different issuers and industries.
How to buy bonds?
Bonds can be a great addition to your investment portfolio, offering a more stable source of income than stocks. Here are the ways you can buy bonds:
Through a Brokerage Account
Buying bonds through a brokerage account is similar to buying stocks. But keep in mind that different brokers may charge different fees, and there can be many bond choices per company. To make sure you’re investing in a reliable company, it’s important to do your research and ensure the company can pay its bonds.
Bond Mutual Funds or ETFs
If you prefer a hands-off approach, bond mutual funds or exchange-traded funds (ETFs) may be the way to go. These funds allow you to invest in a variety of bonds without having to choose which ones to purchase. The company managing the fund will typically organize the bonds by type or duration. ETFs can be especially attractive because they offer diversification across a range of bond types, charge low fees, and are often tax-efficient.
Treasury Direct
The US federal government offers a service called Treasury Direct, which allows you to buy Treasury bonds directly. This means you can avoid fees charged by brokers and purchase bonds directly from the government. It’s important to note that Treasury bonds are generally considered low-risk investments and are often used as a hedge against market volatility.
Types of bonds
When regular people buy bonds, they usually choose between government bonds or corporate bonds. However, there are also mortgage-backed securities which are bonds issued by government-sponsored agencies.
Here are the types of bonds that ordinary investors can purchase:
Treasurys
Treasurys are basically bonds issued by the US federal government. They’re known for being low-risk, meaning that you’re not likely to lose your money if you invest in them.
Although the returns on Treasurys are not particularly high, they’re backed by the “full faith and credit of the United States”. That’s a fancy way of saying that the US government guarantees them. The US government is one of the most reliable borrowers in the world, which is why Treasurys are considered a risk-free investment. However, keep in mind that nothing is entirely risk-free.
Compared to bonds issued by foreign governments, Treasurys are generally considered safer. However, foreign government bonds may offer higher yields, although they may also carry more risk.
Savings Bonds
Did you know that the US government also issues savings bonds? These are a unique kind of bond that lets you save money directly with the government.
Savings bonds work a bit differently from regular Treasurys. They don’t pay out the interest you’ve earned until you redeem the bond. This means that you’ll need to hold onto the bond for a while before you see any return on your investment.
Savings bonds can be a great way to save money over time, and they’re backed by the US government. So, if you’re looking for a secure and reliable way to invest your money, savings bonds could be a good option. Just keep in mind that they might not offer the same kind of returns as other types of investments.
Municipal Bonds
Municipal bonds, or “munis” for short, are a kind of government bond issued by state or local governments.
One of the main advantages of munis is that the returns they generate are usually exempt from federal taxes. Plus, in some cases, they’re also exempt from state and local taxes. This means that you get to keep more of the money you earn from your investment.
Munis can be a good option for people who are looking for tax-free investments. They’re typically less risky than other types of investments, although they may not offer the same kind of returns. If you’re interested in investing in munis, it’s a good idea to talk to a financial advisor who can help you figure out if they’re the right choice for you.
Corporate bonds
Corporate bonds are basically loans that companies offer to investors in exchange for a return. These bonds are issued by large companies, both in the US and abroad.
The interest rates on corporate bonds can vary depending on the creditworthiness of the borrower and how long the bond will last. Longer-term bonds usually have a higher yield than short-term bonds.
Corporate bonds can be divided into two main categories:
- Investment-grade bonds: issued by companies that have a credit rating of at least triple-B from credit-rating agencies like Standard & Poor’s and Moody’s. These bonds are generally considered less risky and offer lower returns.
- High-yield bonds: also known as junk bonds, issued by companies with lower credit ratings. These bonds carry a higher risk, but they also offer higher returns than investment-grade bonds.
Mortgage-backed securities
Mortgage-backed securities, or MBS, are a special kind of bond created by government-sponsored enterprises like Fannie Mae and Freddie Mac.
MBS work by pooling together thousands of mortgages from homeowners. The payments on these mortgages are then used to pay out returns to investors who hold the bonds.
It’s important to note that bonds issued by Fannie Mae and Freddie Mac are not guaranteed by the government. However, bonds issued by government agency Ginnie Mae (and by other firms qualified by Ginnie Mae) are backed by the federal government.
If you’re thinking about investing in MBS, it’s a good idea to do your research and understand the risks involved. MBS can be complex and may be affected by changes in the housing market or interest rates.
Pros of investing in bonds
1. Safety First
One of the main benefits of investing in bonds is that they’re generally considered to be a safe
investment. Unlike stocks, bond prices tend to be less volatile, meaning you’re less likely to lose a lot of money in a short amount of time. So, if you’re looking for a way to preserve your capital while still earning a decent return, bonds could be a good option.
2. Predictable Income
Another advantage of investing in bonds is the predictable income stream they offer. When you buy a bond, you’ll receive a fixed amount of interest twice a year, which can be a great way to supplement your income. Plus, if you hold the bond until it matures, you’ll get your principal back, so you’ll know exactly how much money you’ll make.
3. Investing in Your Community
If you’re interested in making a positive impact in your community, investing in municipal bonds could be a great way to do it. When you buy a municipal bond, you’re essentially lending money to your local government to fund public projects like schools, hospitals, and parks. So, not only are you earning a return on your investment, but you’re also helping to improve your community.
4. Diversification is Key
Perhaps the biggest benefit of investing in bonds is the diversification they bring to your portfolio. While stocks have historically outperformed bonds, having a mix of both can help reduce your financial risk. As you get older and become more concerned with preserving your wealth, you may want to allocate a greater percentage of your funds to bonds. By doing so, you can still earn a decent return while minimizing your exposure to market volatility.
Cons of investing in bonds
1. Tied Up Funds
One of the biggest drawbacks of investing in bonds is that they typically require you to lock your money away for extended periods of time. This means that if you need access to your cash, you may not be able to get it without incurring significant penalties.
2. Interest Rate Risk
Because bonds are a relatively long-term investment, you’ll face the risk of interest rate changes. If interest rates rise, the value of your bond may decrease, making it harder to sell or trade. So, if you’re considering buying bonds, it’s important to pay attention to the current interest rate environment and adjust your strategy accordingly.
3. Default Risk
While it’s rare, there’s always a risk that the issuer of a bond will default on its obligations. If this happens, you could lose out on interest payments, principal repayment, or both. So, it’s important to do your due diligence and invest in bonds issued by financially stable companies or governments.
4. Lack of Transparency
Another downside of investing in bonds is the lack of transparency in the bond market. Unlike stocks, which are traded on public exchanges, bonds are typically bought and sold over-the-counter. This can make it harder to determine whether the price you’re being quoted is fair, and brokers can sometimes get away with charging higher prices.
5. Lower Returns
Finally, one of the biggest drawbacks of investing in bonds is the lower return on investment compared to stocks. While bonds are generally considered to be a safer investment, they typically offer lower returns over the long term. So, if you’re looking to maximize your earnings, you may want to consider investing in a mix of both stocks and bonds.
Popular bond-buying strategies
If you’re investing in bonds to make some cash, you’re probably sweating over interest rates and which way they’re heading – up, down, or staying put.
When interest rates go up, the value of your bonds drops, and when they go down, it goes up. But bond investors also worry about “reinvestment risk,” which means they might not make a good return when their bond matures.
So, bond investors are always looking for the right balance between the income they’re getting from their bond portfolio right now and the income they could earn in the future. Here are some popular tricks they use to make that happen:
1. Ladders
One strategy that some investors use is called building a bond ladder.
Here’s how it works: You buy bonds with different maturities, so that they “stagger” like rungs on a ladder. For example, you might buy bonds that mature in one year, two years, three years, four years, and five years. When the one-year bond matures, you reinvest the money in a new bond with a five-year maturity. When the two-year bond matures, you invest in a new five-year bond, and so on.
The idea behind this strategy is to minimize something called “reinvestment risk.” That’s the risk that you’ll reinvest your money at a lower rate when your bond matures. By having a ladder of bonds that mature at different times, you can reduce this risk.
But that’s not all. Building a bond ladder can also help you capture rising interest rates in the future. If rates go up, the longer-term bonds at the top of your ladder will be earning more interest than the shorter-term bonds at the bottom. This can help you get a better return over time.
Of course, there are some downsides to this strategy. For one thing, it can be more complicated than just buying a single bond. You need to keep track of when each bond matures, and you may need to buy and sell bonds more often. Also, building a bond ladder won’t give you the highest returns possible. If you’re willing to take on more risk, you might be able to get a better return with other types of investments.
Still, if you’re looking for a relatively safe and steady way to invest in bonds, building a ladder might be worth considering.
2. Barbells
If you’re looking to invest in bonds and want to balance risk and reward, you might consider a strategy called “barbelling.” With this approach, you buy both short-term and long-term bonds, but skip the medium-term bonds in between. Here’s how it works.
First, you buy some short-term bonds with maturities of one to three years. These bonds won’t earn as much interest as longer-term bonds, but they’ll give you some cash flow and stability.
Next, you buy some longer-term bonds with maturities of 10 years or more. These bonds will pay higher interest rates than short-term bonds, but they also come with more risk. If interest rates rise, the value of these bonds could drop.
By investing in both short-term and long-term bonds, you’re creating a “barbell” shape on a graph of bond maturities. This approach can help you capture the higher yields of long-term bonds while still having access to some cash with short-term bonds.
Of course, there are some risks to be aware of. Long-term bonds can be volatile if interest rates rise, and you’ll need to monitor your investments carefully to make sure you’re not taking on too much risk.
Still, barbelling can be a good strategy for investors who want to balance safety and yield. By having some short-term bonds to fall back on, you’ll be better positioned to weather market downturns. And by investing in longer-term bonds, you’ll have the potential for higher returns over time.
3. Bullets
If you’re planning for a big expense in the future and want to invest in bonds, a timing strategy might be the way to go. With this approach, you buy bonds over a period of time that mature at roughly the same time as when you need the money. Here’s how it works.
Let’s say you know you’ll need a big chunk of cash in five years. You could start by buying a five-year bond now. Then next year, when you have more money, you could buy a four-year bond. In three years, you could add a two-year bond. Then at the end of the original five-year period, you’ll have all the money available at the same time when you need it.
The idea behind this strategy is to time your investments so that the money is available when you need it. It also allows you to take advantage of changing interest rates over time.
Of course, you’ll need to do some planning to make this strategy work. You’ll need to think about how much money you need and when, and then buy bonds that mature at the right time. You’ll also need to consider how the market and interest rates might change over time, and adjust your investments accordingly.
Are bonds a good investment?
Bonds can be a good investment for some people, depending on a few factors. Compared to stocks, bonds tend to be less risky but offer lower returns, especially for U.S. Treasury bonds. However, this doesn’t mean that bonds are always a bad investment. Bonds can help reduce volatility in a bumpy stock market, which can make a positive impact on your portfolio overall.
Like any investment, the returns on bonds depend on when you buy them. If you buy bonds before interest rates rise, the bond prices may decrease. However, you will still get your principal back when the bond matures, which may take many years. On the other hand, buying bonds right before rates fall can result in an immediate capital gain in addition to interest payments.
If you’re nearing retirement, having a significant bond position in your portfolio is a good idea. Market cycles can last several years, and if the stock market starts to decline when you’re close to retirement, your stocks may not have time to recover. This could force you to work more years than expected, jeopardizing your retirement date.
It’s recommended to add more bonds to your portfolio as you approach retirement to reduce your risk over time. By doing this, you can lock in a comfortable and financially secure retirement.
Can bonds make you lose money?
Absolutely. Let’s break it down. Bond prices have a tendency to move in the opposite direction of the overall economy. So when the economy is booming, interest rates go up, and bond prices go down. When the economy slows down, interest rates drop, and bond prices go up.
Therefore, if you decide to sell a bond when the interest rates are lower than when you initially bought it, you can expect to earn a profit. However, if you choose to sell when interest rates have gone up, then you can end up losing money.
It’s always a good idea to do your research and be mindful of the market trends before you buy or sell bonds. This can help you avoid making any hasty decisions that might lead to losses.
How much should you invest in bonds?
As you plan for retirement, it’s important to consider how much of your portfolio should be allocated towards bonds. A common standard for those in midlife is to have a 30% allocation in bonds, which should gradually increase as you approach retirement.
The reason for this is that bonds provide a steady stream of income for investors, and their prices generally don’t fluctuate as much as stocks. This stability ensures that you have a more reliable source of income and assets during your retirement years.
What to look out for when buying bonds?
Buying bonds can be a smart way to invest your money, but there are risks to be aware of. The biggest mistake people make is going for the bonds that pay out the most, also known as the highest yields. While a high yield might seem attractive, it could actually be a red flag.
The two main risks for bond investors are whether the issuer will pay back the bond with interest and whether interest rates will rise. If the issuer can’t pay back the bond or rates go up, the bond will lose value. When this happens, the yield – the percentage of the bond’s price that it pays to investors – goes up.
High-yield bonds can be a warning sign. If investors are expecting to receive less than the full face value of the bond, then it will be cheaper and will offer a higher yield.
Another reason a bond might have a high yield is that it has a long duration, maybe 10, 20 or even 30 years. These bonds offer a higher yield to compensate investors for locking their money up for such a long time. But if interest rates rise, these long-term bonds can lose a lot of value. It’s important to remember that although you may eventually recover the full face value of the bond when it matures, it could take many years, especially for government bonds with long-term maturities.
To avoid these traps, it’s a good idea to carefully examine high-yield bonds or consider having professionals do it for you. Keep in mind that when it comes to investing, sometimes the safest option is the best option.