How to Invest in Bonds

What are bonds?

A bond is a loan to an organization that is looking to raise a large sum of money to help pay for certain projects. These organizations can include corporations as well as governments at the federal, state and local levels. For example, local governments can issue bonds to help finance infrastructure projects like building roads, schools, and parks. 

Bonds are considered a type of fixed-income investment because they typically provide a predictable stream of income in the form of interest payments throughout a specified period of time. There are many different types of bonds, but the basic categories that you will commonly come across include US Treasury bonds, municipal bonds, and corporate bonds. 

How do bonds work?

Companies and government entities issue bonds when they need to borrow money. When you purchase a bond, you are basically giving a loan to the issuer (borrower). Think of it as a more sophisticated version of an IOU. 

Bonds come with a specific set of borrowing terms. Under these terms, the borrower promises to pay you back for the original sum of the loan (principal or face value) by a certain date (maturity date). 

In addition, you will also receive regular interest payments from the borrower. The interest payments are usually set at a fixed, pre-determined rate (coupon rate). But there are bonds with variable interest rates, and as the name implies, this means the interest rate can go up or down over time. 

Let’s look at a basic example: If you buy a 10-year bond at the face value of $1,000 with a fixed 5% coupon rate, you will receive a total of $50 in interest payments ($1,000 x .05 = $50) every year until the bond matures. The frequency of the interest payments can be either semiannual ($25 every six months) or annual. When the bond is due in 10 years, you will also get back the original $1,000 you invested. 

Where can you buy bonds?

There are three main ways to buy bonds:

• US Department of the Treasury. You can purchase US government bonds directly from the United States Treasury (via Treasury Direct) with no maintenance fees. You would need to create an online account by providing a Social Security number, email address, and bank account. You must be at least 18 years old to open an account and purchase bonds at Treasury Direct.
• Brokerage firm. At a brokerage firm, you have the option of purchasing Treasury bonds as well as other types of bonds (e.g., corporate bonds and municipal bonds). The minimum age requirement to open an individual brokerage account varies state to state. Generally, in many cases, you have to be at least 18 years old.
• Mutual funds and exchange-traded funds (ETFs). Buying bonds can be expensive because many bonds have high minimum purchase requirements. This is when buying through a mutual fund or an exchange-traded fund (bond ETFs) may be helpful. These funds can give you access to a diversified pool of bonds at a low cost.    

Just like cash, bonds come in a variety of denominations – for example, $1,000, $5,000 or more. Some bonds have a minimum purchase requirement. But you can start investing in US Treasury bonds with as little as $25. 

Why do people invest in bonds?

Bonds are a basic but important building block of a balanced investment portfolio and can offer three main benefits:

1. A steady flow of interest income. Generally, bonds make interest payments twice a year at a fixed rate.
2. Stability during a volatile market. Because fixed-income investments like bonds are typically protected from the volatility of the stock markets, people often look to bonds as a way of diversifying or spreading risk in their investment portfolios.
3. Potential tax savings. Some bonds, like municipal bonds, can even provide tax-free earnings.

What are the potential risks of bonds?

Keep in mind that investing involves risk – no matter the type of assets you’re considering. While there’s potential for you to earn a return, there’s also a risk that you may lose money, including your principal. Here are some common risks to be aware of if you’re thinking about investing in bonds.

• Credit risk. This is when a bond issuer defaults on its payment obligations – for instance, when they fail to make interest payments to you on time.
• Interest rate risk. Interest rates can go up or down at any time. When interest rates go up, the value of previously-issued bonds fall. For investors looking to sell their older bonds on the market before maturity, they’d typically have to sell them at a discount – in other words, for less than the original face value and therefore, lose money.
• Inflation risk. Inflation is when there’s a broad increase in the prices of goods and services, which can reduce purchasing power over time. Sustained high inflation can erode the value of money, and this can be a potential risk for bond investors who are receiving fixed interest rate payments.