- A bond is essentially a loan an investor gives to a lender, such as a corporation or government.
- Corporate bonds, government bonds, and municipal bonds are the most common types of bonds.
- Bonds can be bought as ETFs on the stock market or individually on the bond market.
Want to invest in bonds? You’ve come to the right place.
This beginner’s guide will walk you through everything you need to know about bonds and bond investing. It isn’t as hard as it seems. After reading this guide, you’ll have a thorough understanding of what bonds are and how you can invest in them. Ready to dive in? Let’s start.
In this section, you’ll learn all the basics of bonds, including what they are and some common terms surrounding them.
What is a bond?
Forget about the fancy definitions. A bond is literally just a loan that an investor gives to a lender. The lender is known as a bond issuer.
The bond issuer could be a corporation, the Federal government, state government, local government, or even foreign governments. For example, a company needs money. They issue bonds. You buy a bond at $100. After one year, the company promises to pay you back in full plus $2 in interest. You get back $102 back. You earned $2.
Why are bonds issued?
So, now that you know what a bond is, why are they issued? Bonds are issued by corporations and governments to raise money. It’s just one of the many ways they can access large amounts of money for cheap.
If you and I need access to a lot of money, we can take out a bank loan. However, large corporations and governments can’t do that, nor would it be smart to do because bank loans have higher interest rates.
For instance, let’s say Coca-Cola needed to raise money to fund the development of a new beverage. It would be much smarter for them to issue low-interest bonds to investors than to take out high-interest loans from a bank.
Both would require them to take out debt, but issuing bonds would be cheaper than a bank loan. Does that make sense? No one likes paying interest, not even a multi-billion dollar company. Bonds are just one of the ways a corporation or government can raise money.
For example, another common way a corporation can raise money is by selling stock.
Stock represents ownership. When you buy a share of Coca-Cola stock, you are technically buying a small piece of the company. Fixed-income securities, such as bonds, are a form of debt that the company or government has to pay back with interest.
Common bond terms
Let’s go over some common bond terms you will often see when investing in bonds.
The par value (or par amount) of a bond refers to the bond’s face value. It’s the amount of money you purchased the bond for and can expect to get back when the bond matures.
For example, if you purchase a bond for $1,000, the bond’s par value is $1,000. When the bond matures, you should receive your original $1,000 in return. Par is the Latin word for equal. That’s where the term par value comes from—equal value. Leave it up to the finance world to make things more complicated than necessary.
No, this isn’t referring to the coupons you get for McDonald’s in the mail. In the finance world, a coupon represents the interest payment on a bond. It’s the amount of money a bond will pay you each year.
It’s called a coupon because back in the day, bond payments were sent via mail. You received an actual piece of paper in the mail that you had to clip off to redeem. The same way you clip off a coupon.
The coupon rate is the yield paid by a bond. Yield refers to the amount of money an investment pays you over time and is usually represented as a percentage. For example, if a bond pays $70 every year and you purchased the bond for $1,000 (also known as par value), the yield would be 7%.
That’s because $70 divided by $1,000 is 0.07, or 7%. The coupon rate is simply the sum of coupon payments divided by the par value.
When talking about bonds, maturity refers to the agreed-upon date in which the original value (par value) of the bond must be paid back to the investor.
For example, if you purchased a $1,000 1-year bond, the bond’s par value is $1,000, and the term of maturity is one year. After one year, the bond will mature, and you will get back your original $1,000 (the par value) plus any outstanding interest.
When a bond matures, the borrower must pay back the investor the full principal plus any outstanding interest. If the bond isn’t paid back, this could cause the bond to default, which would hurt the borrower’s credit rating.
Investing in bonds
There are a few different ways you can invest in bonds. Some of these bond investing strategies have more benefits than others. However, all of them have pros and cons.
Let’s go over all of them in detail.
Top bond ETFs
- iShares Core U.S. Aggregate Bond ETF (AGG)
- Vanguard Total Bond Market ETF (BND)
- iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
- iShares TIPS Bond ETF (TIP)
A bond fund is simply a mutual fund or ETF that invests only in bonds. Out of the two, bond ETFs are my favorite. I’ll explain why.
For starters, ETFs, in general, are more flexible than mutual funds. This is because ETFs trade on the stock market, which means you can buy and sell them throughout the day. Mutual funds only trade once per day at the end of the day.
Buying bond funds have many advantages over buying individual bonds. For example, when you buy a bond fund, you are buying a basket of various bonds. This gives your portfolio instant diversification.
Also, unlike individual bonds that have maturity dates, bond funds don’t. This means your money doesn’t have to be tied up long-term while you wait for the bond to mature. If you buy individual bonds, you’ll have to wait for them to mature before getting your original investment back.
You could technically sell the bond on the secondary bond market, but you’ll likely not get your full investment back because of interest rate risk (discussed later in this guide).
You can buy bond ETFs from any broker. If you already have a brokerage account, just use that account. If you don’t have one or are looking for a new one, I’d recommend going with either Webull or M1 Finance.
Both allow you to invest in bond ETFs and take advantage of adding another layer of diversification to your portfolio.
If you want to invest in Treasury securities such as T-bonds, T-notes, and T-bills, you can do it for free using TreasuryDirect.gov. The website is a little dated and can be hard to navigate at times, but signing up is completely free.
You can also buy Treasury securities from a broker, but you’ll typically be charged a fee to do so. If you buy from Treasury Direct, you won’t pay a fee.
From a broker
If you want to buy individual bonds, an easy place to do that is through a brokerage account.
Not all brokers offer bonds. But the brokers that do will allow you to buy any type of bond—corporate, municipal, agency, even Treasury securities.
You should be aware that most brokers will charge a fee for buying and selling bonds. For example, TD Ameritrade, Fidelity, and Vanguard all charge $1 when trading bonds on the secondary bond market.
Fees can also be charged on Treasury securities, which can be avoided if you buy directly from the U.S. Treasury using TreasuryDirect.gov.
Types of bonds
There are four main categories of bonds. In this section, you’ll learn about each type and how you can use them in your investment strategy.
Here are the four major types of bonds:
Let’s go over each bond type in detail.
Corporate bonds are issued by corporations to raise money to fund various business activities. There are two primary types of corporate bonds:
- Investment-grade corporate bonds
- High-yield corporate bonds
Let’s talk about both.
Investment-grade corporate bonds
Top investment-grade corporate bond ETFs
- iShares Long-Term Corporate Bond ETF (IGLB)
- SPDR Portfolio Long Term Corporate Bond ETF (SPLB)
- Vanguard Long-Term Corporate Bond ETF (VCLT)
Investment-grade corporate bonds are considered safe investments. These bonds are rated highly because they have a low risk of default. This basically means the odds of you losing your money are small.
You’ll typically find investment-grade bonds associated with blue-chip companies. These are very well-established, reliable companies that have a strong history of sustained growth. Think of companies like Amazon, Google, Coca-Cola, Goldman Sachs, Nike, and Walmart.
Because investment-grade bonds are safer, they also pay less interest. Think of someone with a 750 credit score versus someone else with a 550 credit score.
The person with a higher credit score will receive lower interest rates on their loan than the person with a low credit score. The bank sees the high credit score borrower as less of a risk, therefore gives them lower interest rates.
On the other hand, the low credit score borrower is seen as a risk, therefore receives a higher interest rate on their loan. It works the same way with bonds. Companies that have higher bond ratings will pay investors less interest than companies with low bond ratings.
High-yield corporate bonds
Top high-yield corporate bond ETFs
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG)
- SPDR Barclays High Yield Bond ETF (JNK)
- Xtrackers USD High Yield Corporate Bond ETF (HYLB)
High-yield corporate bonds are also known as non-investment grade bonds or junk bonds. Companies that have struggled financially or have limited growth history, such as start-ups, are typically issuers of these bonds.
Using our example from earlier, you can think of a high-yield bond as a person with a 550 credit score. When you invest in high-yield corporate bonds, you are taking on more risk. However, this also means you will get higher return rates since high-yield bonds have higher interest rates.
Like with anything in the investment world, the riskier the investment, the higher the returns. The safer the investment, the lower the returns. Are you willing to take on more risks to reap a larger return? Or do you prefer to play it safe and settle for smaller returns? There is no right answer. It strictly depends on your situation.
Top high-yield corporate bond ETFs
- iShares 1-3 Year Treasury Bond ETF (SHY)
- Vanguard Short-Term Treasury ETF (VGSH)
- iShares U.S. Treasury Bond ETF (GOVT)
The term government bond is a broad term used to describe different types of bonds issued by various governments worldwide. In the U.S., when someone talks about government bonds, they are most commonly referring to Treasury securities.
Treasury securities are often considered risk-free investments because they are backed by the full faith and credit of the U.S. government. The government has the power to print more money or increase taxes if it needed to repay its debts.
Many investors use Treasury securities to preserve their money rather than increase it. You see, if your money were just sitting in a low-interest savings account at your bank, it would be losing value each year due to inflation.
So the trick is to make your money not lose value. And if you’re more risk-averse, meaning you want to avoid risk, then a Treasury security is a good place to invest your money.
There are several reasons why you would benefit from adding Treasury securities to your portfolio. The primary advantage is that the interest you earn from the bonds is tax-free at the state and local level.
However, the interest is still subject to federal taxation. Treasury securities come in many different shapes and sizes. Let’s go over some of the most popular types.
Treasury bonds, also known as T-bonds, are the granddaddy of all Treasury securities. They are long-term bonds that have a maturity between 20 and 30 years. I know, that’s a long time. However, this doesn’t necessarily mean you are stuck with them for three long decades. You can always sell the bonds on the OTC market or to another investor.
You are not obligated to hold T-bonds until they mature, you can sell them before they mature. T-bonds pay a fixed rate of interest every six months until maturity. Because T-bonds have longer maturities, they tend to pay out higher interest. This is unlike T-bills, which have shorter maturity lengths but also pay lower interest rates.
Like with any Treasury security, T-bonds are sold in increments of $100. You can buy them directly from the U.S. Treasury at TreasuryDirect.gov, or broker.
If T-bonds are the grandaddy of Treasury securities, Treasury notes (T-notes) are the big brother. T-notes are intermediate-term bonds with maturities ranging from 2, 3, 5, 7, and 10 years. Like T-bonds, you are not required to hold T-notes until maturity. If you want to sell them early, you can on the OTC market, also known as the secondary bond market.
Interest on Treasury notes is paid every six months. T-notes sell in increments of $100. You can buy them directly from the U.S. Treasury at TreasuryDirect.gov, or broker.
Treasury bills (T-bills) are the little brother of T-bonds. T-bills are short-term securities that mature in one year or less from their issue date. You can buy T-bills with maturities ranging from 4 weeks to 52 weeks.
T-bills are a little different from other Treasury securities in how you earn interest from them. Because T-bills have shorter maturities, they do not pay interest every six months.
Instead, when you purchase T-bills, you buy them at a discount below their face value (par value). Therefore, the interest you earn on it is equal to the face value minus the purchase price. Let me explain this with an example.
T-bills sell in increments of $100. However, when you buy a T-bill, you are not buying it at $100. Instead, you are buying at a discount below $100, such as $99.993778. Since you are buying them at a discount below $100, when the T-bill matures, you’ll get back the par value of $100, thus earning you $0.006222 per T-bill. Make sense?
Treasury inflation-protected securities (TIPS)
Treasury inflation-protected securities, or TIPS, are a type of Treasury security that’s par value adjust to inflation or deflation. The TIPS principal will increase or decrease depending on the Consumer Price Index, which is how inflation and deflation are measured.
I know that was a lot of words, so let’s break it down with an example. Let’s say you buy $100 worth of TIPS. The $100 that you paid is the par value of the security, also called the principal.
If inflation increases, the spending power of your dollar decreases. That’s how inflation works. In the U.S., inflation increases by 3% per year on average. This means a burger that costs $1 now will cost $1.03 next year. Inflation is causing your dollar to be less valuable.
And that’s where TIPS become useful. By investing in TIPS, your money is automatically protected against inflation. If inflation increases by 3%, your TIPS par value will also increase by 3%. TIPS are sold in multiples of $100 and can be purchased from the U.S. Treasury at TreasuryDirect.gov, or by broker.
Top municipal bond ETFs
- iShares National AMT-Free Muni Bond ETF (MUB)
- Vanguard Tax-Exempt Bond Index ETF (VTEB)
- SPDR Barclays Short Term Municipal Bond (SHM)
Municipal bonds (also called munis) are issued by state, city, or county governments. Like with any bond, municipal bonds are issued to raise money.
Typically, the money raised is used for expenses that add value to the state or local community. For example, municipal bonds might be issued by your local township to raise money to restore the old courthouse.
The state might issue municipal bonds to raise money for roads, highways, and bridges. The county might issue municipal bonds to build airports, schools, and power plants. These are all things that will be around for decades and improve the quality of life for residents in that area.
There are several reasons why you would benefit from adding municipal bonds to your portfolio. However, the primary advantage is that the interest you earn from the bonds is tax-free at the federal level.
This means come tax season Uncle Sam won’t go reaching into your pockets. However, they are still taxed at the local and state level.
Agency bonds are securities issued by government agencies other than the U.S. Treasury. There are two types of agency bonds:
- Federal government agency bonds
- Government-sponsored enterprise (GSE) bonds
The primary difference between these two types of agency bonds is that one is backed by the full faith and credit of the U.S. government, and the other isn’t.
Federal government agency bonds are issued by federal agencies such as:
- Federal Housing Administration (FHA)
- Small Business Administration (SBA)
- Government National Mortgage Association (GNMA)
The U.S. Treasury backs all of these. Because of that, they are considered very safe investments. On the other hand, government-sponsored enterprise (GSE) bonds are not technically government agencies. Instead, they are private companies supported by the government.
But just because they are supported, doesn’t mean they are backed by the full faith and credit of the U.S. government—they are not. Because of that, these types of bonds do have a risk of defaulting. That also means they yield higher interest rates, which may be attractive to some investors.
Benefits of investing in bonds
Bonds aren’t necessarily the most exciting investments in the world, but that doesn’t mean they aren’t worth adding to your portfolio.
Let’s discuss a few of the benefits of investing in bonds.
Bonds are considered to be very safe investments across the board. If you need a place to put your money and don’t want to risk it in other investments such as stocks, bonds are the way to go.
For starters, government bonds such as Treasury securities are backed by the full faith and credit of the U.S. government. Because of the vast size of the U.S. economy, it’s safe to assume that the government will likely never default on its bonds.
If the government needed money to pay back bondholders, there are several ways it could raise capital, such as with taxes. Corporate bonds are safe as well, especially when comparing them to stocks.
You see, a company can issue both stocks and bonds to raise money. However, both are fundamentally very different securities. Bonds are a type of debt, whereas stocks are a type of equity.
If a company were to go bankrupt, debtholders (those who own bonds) have priority over shareholders (those who own shares of stock). This priority simply means that debtholders will likely get back some of their money, whereas shareholders will often lose their entire investment.
Unlike stocks, which move irrationally and can provide unpredictable returns, bonds are stable. Bonds provide a predictable stream of income, which is perfect if you want to know exactly what your return on investment will be.
Most bonds have a fixed interest rate (known as coupon rate) and pay you twice per year. After the bond matures, the bond’s par value is returned back to you along with any outstanding interest. This also makes bonds a great way of preserving your money while gaining a little bit more on top.
By adding bonds to your investment portfolio, you can offset the volatility of other securities such as stocks. A lack of portfolio diversification can lead to portfolio volatility which can damage your long-term returns.
The idea behind diversification is to get a healthy balance of the right investments based on your investing goals and risk tolerance. Ultimately, you should be aiming to maximize returns while minimizing volatility.
If your portfolio is made up of 100% stocks or equities, you may (will) experience some unnecessary volatility, which will eat into your long-term gains. By investing in bonds, you can help balance your portfolio so that when the stock market is down, your entire portfolio isn’t also down.
The best way to diversify your portfolio with bonds is to purchase bond funds such as ETFs and mutual funds. These funds are made up of hundreds of bonds that give you instant diversification compared to buying an individual bond. Buy bond ETFs in your brokerage account.
Risks of investing in bonds
Bonds are considered very safe investments. However, like with any investment, there are always risks involved, even if they’re rare. Let’s go over some of the risks of investing in bonds.
Bonds are subject to default risk. If a bond issuer defaults on their bond, it’s safe for you to say you are out of your money. Forever.
In most cases, it’s unlikely that a bond will default, especially if you are investing in investment-grade corporate bonds and Treasury securities. However, it can and has happened, especially with more risky bonds such as high-yield bonds.
Interest rate risk
Because bonds are generally long-term investments, you may face interest rate risk. Let me explain what this means with an example.
Let’s say XYZ Company issues 1-year bonds with a par value of $1,000 and a fixed interest rate of 3%. This means one year from now, XYZ Company will pay you back $1,030 (3% interest on $1,000 is $30) when the bond matures.
You decide to buy one bond for $1,000 today. But what if you bought the bond today, and then tomorrow the interest rate on that same bond goes up to 5%? Well, you’re locked in at 3%, remember?
So now, not only is your money stuck in a bond that is worth less, but you can’t even sell that bond for its face value of $1,000 on the secondary bond market. Why would anyone buy it? They could buy the same bond for $1,000 that has a 5% interest rate instead of buying your $1,000 bond that has a 3% interest rate.
If you want to sell the bond, you’d have to sell it at a discount below its $1,000 face value. And is that even worth it? Probably not. So you keep the 3% interest rate bond and just accept that you could have earned 2% more interest if you waited a few days to buy the bond.
Interest rates can change (and often). Therefore, you run the risk of your bond becoming worth less than what you originally bought it for.
This can also work in your favor. If you buy a 5% bond and the next month that same bond is now being issued at 3%, your bond becomes more valuable and desirable on the secondary bond market.
Because bonds are generally safe investments, they tend to have smaller returns than other investments like stocks and real estate. The safer the investment, the smaller the return. This is a universally accepted fact.
For example, your savings account at your bank is the least risky investment in the world. And yet, the interest you earn on your money is so low, you are actually losing money to inflation over time. If you have a lower risk tolerance and don’t want to put your money in the stock market, investing in bonds is great for you. You’ll earn more than you would if your money was sitting in a bank or CD.
Bonds require you to lock up your money for long periods. Although bonds can be sold on the secondary bond market to another investor before they mature, it is not guaranteed they will sell.
This means your money could potentially be wrapped up for as much as 30 years with a T-bond. This, of course, is the absolute worst-case scenario. The risk of liquidity can be fixed by purchasing bond funds such as ETFs instead of individual bonds from issuers.
Bonds aren’t the most exciting investments in the world, but they’re stable and effective.
Generally speaking, if you’re younger and have at least 10+ years before your planned retirement, most of your investment portfolio should be made up of more aggressive investments such as stocks, real estate, and other high yielding investments.
However, there should always be a place in your portfolio for bonds. Bonds will provide diversification and reduce portfolio volatility, which can harm the effectiveness of your long-term compound interest.
Although bond investing may seem mundane, the process of investing in them is as simple as buying a bond ETF or mutual fund. By adding bonds to your portfolio, you’ll enjoy more diversification, which will increase your long-term returns massively.
About the author