Bond investing can yield many benefits. There are many different types of bonds that can be used to accomplish an assortment of investment objectives. Bonds can offer preservation of principal, tax-free income, and even capital gains in some cases. But before you venture out into this frontier, you’ll need to know the basics of how these instruments work and what they can do for you. Here we will cover the key concepts of bonds and how they can benefit you.
In the financial world, there are two basic types of investments: equity and debt.
Equity-based investments such as stocks or real estate represent a share of ownership in the issuer. When you buy stock in a company, you become a proportional owner of the company based on the number of shares that you have purchased. For example, say you buy 1000 shares of a company that has a million shares outstanding. You now own one one-thousandth of that company.
In general, equity-based investments are the only type of investment that have outperformed inflation over time. Bonds are safer investments in many respects, but their historical returns have lagged stocks by a substantial margin over the decades.
Debt-based investments make the investor a creditor of the issuer. Bonds are debt-based investments that pay a specific rate of interest for a specific period, such as 10, 20, or 30 years. When you buy a bond, you become a creditor of the issuer. So, when you buy a 30-year government bond, you become a creditor of the U.S. Treasury for the next 30 years (or less if you sell your bond before maturity). Bond investing is appropriate for both individuals and institutions. Bonds are used to transfer money between hands in much of the world.
Bonds are relatively simple types of investments. At their core, they are simply a promise made by the issuer to repay the investor’s principal at a certain point in the future. This point is called the maturity date. The life cycle of a bond is shown as follows:
Bonds with long maturities pay correspondingly higher rates of interest than short-term bonds. For example, the 30-year government bond pays more interest than a one-year T-Bill. Bonds pay interest according to a preset schedule, such as monthly, quarterly, semiannually, or annually until they mature.
Bond maturities can vary widely. Some bonds mature in a month or less while others last for 30 years or more. When it comes to maturities, bond investing can be divided into two main categories. Bonds with maturities of 9 months or more trade in what is called the capital market, while bonds with maturities of less than 9 months trade in what is known as the money market.
Bonds that are first issued by a company, municipality, or government are said to be trading in the primary market, They are issued at what is known as par value, which is typically $1,000 per bond with few exceptions.
Brokers and investment firms distribute these offerings to their customers directly from the issuer. The distributors are paid to do this directly by the issuer. If there is a bond offering that you would like to get in on, just go to your broker and place an order for them.
You will tell your broker that you would like to buy x number of bonds from the offering, and your broker will try to fill your order for you. But if the bond offering is in high demand, it may be difficult for your broker to fill your order.
Anyone who wants or needs to tie their money up for a specific period will look to bonds to meet their investment objectives. If you are a conservative investor and you want to be certain to get your money back, then government or municipal bonds can be a good alternative.
You may be afraid to risk your money in the stock market, due to fear of a market correction. But you may also want a higher rate of return than you can get from Treasury securities. This means that corporate bonds may be just the thing for you. Anyone who needs current income from their investments can satisfy this objective by investing in bonds.
There are three basic types of issuers when it comes to bonds. There is the U.S. Government (and foreign governments), local municipalities such as cities and counties, and corporations. Each type of bond has its own unique characteristics and is appropriate for a specific type of investor. Here we will look at the types of bonds issued by each type of issuer in detail.
As their name states, Treasury securities are issued directly by the U.S. Treasury. They are considered the safest investments on earth by most financial rating agencies and financial analysts. They are backed by the taxing authority of Congress as well as the ability to print money. You can buy Treasury securities here.
Government bonds are sold directly at auction on a regular basis, but you can also buy them in the secondary market either directly or through a broker. There are three main types of Treasury Securities, known as bills, notes, and bonds. In 2018, the average daily trading volume of Treasury securities was $547 billion.
T-Bills – These bonds have maturities ranging from a few days to 52 weeks. They are sold at a discount and then mature at par value. They do not make regular interest payments the way a coupon bond will. The difference in price represents the interest that the investor receives.
T-Notes – These bonds have maturities ranging from two, three, five, seven, and ten years. They pay higher rates of interest than T-Bills because of their longer maturities. They pay interest twice each year and are issued and mature at par value. (From this point on, par value will always refer to a price of $1,000 per bond, regardless of the type of bond that is being discussed.)
T-Bonds – These bonds have maturities of 20 or 30 years, and for this reason, they are commonly referred to as “long bonds”. Like T-Notes, they pay interest semiannually and are issued and mature at par value. Treasury bonds can be purchased in increments of $100.
In addition to Treasury securities, the U.S. government issues two other types of savings bonds, known as I-Bonds and EE Bonds. Unlike Treasury securities, these bonds can only be bought and redeemed directly with the Treasury and do not trade in a secondary market. Like Treasury securities, the rate of interest that they pay is tied to prevailing interest rates but is usually rather low compared to other types of bonds.
I-Bonds (short for Inflation Bonds) pay a combination of fixed and variable interest rates. This gives investors some protection from inflation eroding their purchasing power. The fixed interest rate is set at issuance, while the variable interest rate is adjusted twice a year, in May and November. The variable rate of interest is set according to the performance of the Consumer Price Index for Urban Consumers (CPI-U). When the index rises, the variable rate of interest is correspondingly increased.
This type of savings bond is often referred to as a “Patriot Bond”. Series EE bonds essentially mirror I-Bonds except that there is no variable component to their interest rates. Rates are set twice a year and will remain there for the next six months. Like I Bonds, EE Bonds can be issued as paper bonds or electronically. The electronic bonds are issued at face value and are guaranteed to double in value over the next 20 years. Their maturities can also be extended for another 10 years if the investor so chooses.
TIPS stands for Treasury Inflation-Protected Securities. They are a unique type of savings bond that can be traded in the secondary market. They resemble I-Bonds in that they are adjusted for inflation. But they differ from I-Bonds in how this happens. The coupon rate for TIPS is set at issuance but can be adjusted for inflation once every six months. Furthermore, the principal amount of the bond is also adjusted for inflation.
As their name states, zero-coupon bonds do not pay a coupon rate of interest. They are simply issued at a discount and mature at par value, thus providing the investor with a profit. As mentioned previously, T-Bills are one type of zero-coupon bond. These bonds can be issued by both governments and corporations. Their prices in the secondary market are generally more volatile than other types of bonds. They can rise sharply in price when stock prices fall and vice-versa.
STRIPS are any bond issued by the U.S. Treasury with a maturity of at least 10 years. It has been purchased by an investment firm and had its coupon payments stripped away. STRIPS are not available for purchase directly from the government. They are only available through brokerage and private investment firms. The coupon payments are sold as separate securities while the principal amount is sold at a deep discount and matures at par. While STRIPS are typically created from Treasury securities, they can also be made from other types of bonds.
Certificates of deposit are one of the most common types of bonds available today. Some CDs can only be bought and sold through local banks, while others are issued by national banks and offer higher rates. These specialized CDs are still FDIC insured but often come with a call or put feature (see below). And unlike CDs sold directly by banks, these CDs can trade in the secondary market just like any other type of bond. Ask your broker if their firm has access to this type of CD if you are looking to park some money for a while. The national CDs generally pay rates similar to what corporate bonds pay, but with no risk to principal.
This type of bond is backed indirectly by the U.S. Treasury in one way or another. But they are still technically considered to be riskier than the other types of federal debt covered here. They are usually rated very highly by the bond rating agencies (more on this later). They also pay slightly higher rates of interest than offerings that are directly backed by Uncle Sam. Government agency securities are popular with investors seeking a higher rate of interest with only minimal risk.
Municipal bonds are issued by various municipalities or states. These bond issues are designed to raise money for a municipality and help it meet its financial obligations and maintain the infrastructure within its boundaries. Some muni bonds are also federally insured to increase their safety. Muni bonds in general are not considered to be as safe as government bonds but are much safer than corporate bonds. There are two main types of municipal bonds: general obligation bonds and revenue bonds.
GO bonds are backed by the taxing power and general financial strength of the municipality. For example, a city could do a bond issue of $50 million to be used for repairing roads and bridges or building new parks or other attractions. Investors will receive a stream of interest payments until maturity. And the city or state can raise taxes to meet this obligation if it needs to.
Revenue bonds are bonds that are issued to build a specific facility, road, or other infrastructure-related projects that generate revenue. The revenue generated by the road or facility is then used to make the interest payments to the investor. Revenue bonds are issued to pay for such things as sports stadiums and toll roads.
Corporate bonds are the riskiest type of bonds available. This is because the bonds are only backed by the financial strength of the issuer. The issuing corporation cannot raise taxes or print money to meet its obligations; it can only try to make a profit.
Nevertheless, corporate bonds are still considered to be much safer than most stocks because bondholders will get their money back before the stockholders will if the company has to be liquidated.
There are two main types of corporate bonds. Debentures are backed by the financial strength of the issuing company. Collateralized bonds are backed by a specific type of collateral such as real estate or equipment used by the company.
Convertible bonds are a type of hybrid security. They behave like bonds in many respects, but you can also convert them into a certain number of shares of company stock. This has a marked effect on the price of the bond in the secondary market, because if the company’s stock price rises, the value of the convertible bond will rise along with it. This is one instance where the prevailing interest rate environment may not be the final determinant of the bond’s price. For example, if a convertible bond can be exchanged for 10 shares of the company’s stock at $20 per share, and the share price rises to $65, then the bond is obviously worth much more than its face value.
Bond prices are irrevocably tied to interest rates, and when interest rates are low, new bond issues will pay less. The amount of profit that you can get from a bond depends upon the type of bond you own and your tax bracket. Bonds can pay a little bit more than the rate of inflation, but not a great deal more. If you buy a bond in a primary issuance when interest rates are moderately high and then rates decline, then your bond will be worth more in the secondary market. This means that you can sell your bond at a profit. You will receive a capital gain from the sale of your bonds that you will have to report on your tax return.
If you buy 10 bonds at par value from a primary offering, then you’ll pay a total of $10,000 to the issuing company. Then, if interest rates go down, the value of your bonds in the secondary market might rise to $1,075 apiece. If you sell your bonds at this price, then you will have to report a capital gain of $750 ($75 X 10 bonds) on your tax return the following year.
There are advantages and disadvantages to investing in both stocks and bonds. The pros and cons of investing in bonds include the following:
If you buy a bond, you can count on getting your money back at par value at maturity while collecting interest in the meantime. You can rest assured that you’ll get $1,000 per bond when it matures, regardless of its value in the secondary market. You might even be able to buy the bond at a discount in the secondary market and then redeem it at par and reap an additional capital gain on top of your interest payments. On the other hand, if you buy a bond at par and then interest rates rise, then you will most likely realize a capital loss if you are forced to sell your bonds in the secondary market for any reason.
When you buy a stock, you are purchasing a share of ownership in the issuing company. The share price of the stock will fluctuate somewhat during the trading day and also over longer periods of time. Investing in stocks for the short term can be risky because the markets are unpredictable.
But you can reap much greater rewards from stocks than you can from bonds over longer periods of time. Bonds by nature cannot outpace inflation by very much, but stocks can. If you buy a 30-year government bond, you’ll get a guaranteed rate of interest, but if you buy a group of stocks and hold them for that same period, you’ll most likely grow your money by an exponential amount. This is not possible with bonds.
It all depends upon your risk tolerance, investment objectives, and time horizon. If you are looking for a place to park your money for a month or less, then a money market mutual fund is probably your best bet. If you need reliable income that you can count on for a long period of time, then bonds are a logical choice.
But if you are looking for long-term growth, then you will have difficulty accomplishing this with bonds. And if you do not know whether you will be able to hold your bonds until maturity, then you may realize a capital loss if you must sell them in the secondary market.
The first step that you will take when it comes to investing in bonds is to decide which bonds you want to buy. If you want an absolute guarantee of principal, then government or municipal bonds will be appropriate.
If you’re willing to take a bit more risk in return for a higher interest rate, then corporate bonds may be your best choice. But once you know what you want to buy, the easiest way to start investing in bonds is through a broker or online trading account.
The most common bond investing strategy is to ladder out the maturities in your bond portfolio. For example, say you want to invest $100,000 in bonds. You could do so by following the steps listed below:
You may not want to take the time to evaluate a range of bond issuers. If so, then you may want to consider investing in a bond mutual fund. This type of investment holds a large portfolio of bonds and pays current income to shareholders.
Bond funds provide both diversification and professional management for a fee. (And you need to know what those fees are exactly before you invest.)
There are several key factors that you need to know when you invest in bonds of any kind. They include:
Bonds can comprise a key portion of your investment portfolio. They can provide current income and relative safety of principal compared to stocks. Bond prices move inversely to interest rates, so be sure to check where rates are before you invest. Bond mutual funds can be a good idea if you’re a novice investor, and your financial advisor can probably point you in the right direction if you don’t know where to start.