How to Invest in Bonds

The complicated stuff in life gets a little less complicated when you break it down into six basic questions: What, Why, Who, Where, When and How?

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, governments often issue bonds to finance infrastructure projects like building roads, schools and parks. 

Bonds are a type of fixed-income investment because they typically provide a predictable stream and rate 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 U.S. 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. 

When it comes to bond investing, 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 will 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” or comes due. The frequency of payment can be either semiannual ($25 every six months) or annual. When the bond is due in 10 years, you will get back the original $1,000 you invested. 

Who can buy bonds?

Generally, you need to have a brokerage account to invest in bonds. The minimum age requirement to open an account varies state to state. Depending on where you live, you have to be at least 18 or 21 years of age. 

Where can you buy bonds?

There are three main ways to buy bonds, and you can include all in your bond portfolio:

• U.S. Department of the Treasury. You can purchase a variety of U.S. 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.
• 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). 
• Mutual Funds and Exchange Traded Funds. Buying bonds can be expensive because many bonds have high minimum purchase requirements. This is when buying bonds 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 invest in bonds?

Bonds can offer three main benefits:

• A steady flow of interest income. Generally, bonds make interest payments twice a year at a fixed rate.
• 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.
• Potential tax savings. Some bonds, like municipal bonds, can even provide tax-free earnings. 

When can you invest in bonds?

You can invest in bonds at any time in your life. They are often an important part of a balanced investment portfolio.