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There is no getting away from the fact that the US stock market is in its longest bull run since the second world war.
With that said, bonds are not only an attractive way of hedging against an eventual stock market correction, but they provide a fixed stream of predictable income.
Whether you’re interested in government, corporate, or municipal bonds, there’s an instrument to suit all risk levels.
In this guide, we explore how to invest in bonds, alongside the benefits and risks of entering this marketplace.
How Do Bonds Work?
Once you have a grasp of the basics, bonds are fairly simple to understand. Put simply, bonds are issued by governments (both federal and regional) and corporations as a means to raise financing.
By investing, you become a bondholder, and thus — you’ll be entitled to interest. This interest is usually fixed, so you always know how much you are likely to make on your money. Known as coupon payments, your interest is usually paid every six or 12 months.
Most bonds come with a fixed duration, too. This might be anywhere from a few months to several decades. Either way, when the bonds do mature, only then will you receive your initial investment back. This is known as the principal.
In some cases, such as with US Treasuries, a secondary bond market exists. This allows you to offload your bonds before they mature.
The amount that the market is prepared to pay for your non-matured bonds will be based on various factors, such as the underlying risk of default, demand and supply, and the strength of the US dollar.
Here’s a basic example of how bonds work in practice:
- You buy 100 corporate bonds that are valued at $100 each. This makes your total investment $10,000, which is your principal.
- The bonds have a fixed interest rate of 4% and a duration of 10 years. The interest is paid annually.
- At the end of each year, you receive a coupon payment of $400. This amounts to 4% of the principal investment.
- When the bonds mature in 10 years, you are repaid your initial investment of $10,000.
The above example illustrates that bonds are ideal for those seeking a predictable flow of income.
Ultimately, unless you decide to sell your bonds on the secondary market or the issuer runs into financial problems, you will always know how much money you will make.
Key Point: Bonds can be issued by governments and companies and generally pay a fixed interest rate. In general terms, bonds that are higher-quality (chances of default are low) offer lower interest rates, and shorter maturity bonds (time until repayment) tend to offer lower interest rates.
Ways to Invest in Bonds
If you think that bonds are suitable for your long-term portfolio, you should know that there are various instrument types to consider.
Each bond instrument will come with various risks and yields. This will depend on the financial standing of the issuer, the bond duration, and the amount of capital being raised.
Below we discuss the main ways that you can invest in bonds.
Government bonds come in many shapes and forms. The most used government bond is the Treasury Bonds.
As the name suggests, treasury bonds are issued by the US Treasury Department. Otherwise referred to as T-Bonds (i.e. long-term bonds having a maturity between 10 to 30 years), the bonds are essentially backed by the US government.
In turn, this means that your money is as safe as it gets. After all, should the government experience a short-fall in cash reserves to meet its coupon payments, it will simply print more money.
Treasury bonds are often purchased by large-scale investors when the wider stock markets are uncertain.
Take note, the yields on Treasury bonds are typically attractive — especially those with a short duration. On the flip side, a significant secondary market exists, so you can offload your Treasury bonds at any given time.
Besides Treasury Bonds, there are other types of government bonds including:
- Savings Bonds: These bonds sell at face value and have a fixed rate of interest. Bonds held for 20 years will reach their face value and effectively double.
- Treasury Notes (T-Notes): These bonds are intermediate-term bonds maturing in two, three, five, or 10 years.
- Treasury Bills (T-Bills): These are short-term bonds with a maturity of one year or less.
- Treasury Inflation-Protected Securities (TIPS): These bonds protect investors from the negative effects of inflation or rising prices.
Similar to Treasury Bonds, municipal bonds are issued by government authorities. The key difference is that they are not backed by the federal government. Rather, they are issued by governments on a state and local basis.
Municipal bonds carry a lot more risk than Treasury Bonds as they don’t have the backing of the Federal Reserve. This does, however, mean that you will get a much more attractive rate of return.
Corporate bonds are issued by large companies that are typically listed on the NYSE or NASDAQ. This is sometimes the preferred way of raising capital, rather than giving away more equity.
The yield on corporate bonds can vary quite wildly. This is largely determined by the strength of the company’s balance sheet. In other words, as the likelihood of default increases, the yield will as well.
Perhaps the best way to invest in bonds is via a fund. This works in the same way as a traditional stock market index fund, as you will be investing in a diversified portfolio of assets.
Some bond funds contain thousands of instruments from various government and corporate marketplaces. This is a good way to access the bond market in a passive and diversified manner.
Junk bonds are not for the faint-hearted, as they are issued by corporations that are in a bad state of health.
Additionally, you’ll also find junk bonds issued by governments in emerging markets, such as Venezuela. Junk bonds will suit those with a higher appetite for risk, as the yields on offer are typically well above the market average.
Important: Junk bonds generally have a lower credit rating (BB+ or lower) than investment-grade bonds, and as such offer higher interest rates to attract investors as the chances of default are high.
Ways to Invest in Bonds
Once you have assessed the type of bonds that interest you, you then need to think about how you can invest. The specific options available to you will depend on the type of bond.
This includes the following:
From a Broker
If you’re wondering how to invest in bonds in the most convenient way possible, opt for a traditional online broker.
Many popular platforms give you access to bonds, but you will need to check if your preferred instrument is supported before opening an account with the provider.
In some cases, your chosen bond broker will charge you a variable commission. For example, you might pay 0.1% of the bond value. This means that a $10,000 bond investment would attract a commission of $10.
Some brokers will charge you a flat fee when you invest in bonds. For example, you might pay $1 for each bond instrument that you buy.
The main process of investing in bonds through a broker is as follows:
- You open an account with an online broker and upload some ID to verify your identity;
- You make a deposit via bank transfer or a debit card;
- You select which bonds you want to invest in and the number of instruments that you wish to purchase;
- As and when the bond issuer distributes a coupon payment, this will be paid into your brokerage account; and
- When the bonds mature, the principal will be transferred to your broker, and available to reinvest or withdraw.
There are a lot of brokers offering free trades so you can buy bond ETFs directly from the broker. Here are some recommended brokers to use. These brokers are considered safe, as they are regulated.
Stock and ETF Trades
$0 + ($0.65/contract)
$500,000 (securities up to $500,000, cash up to $250,000)
Stock and ETF Trades
$0 + ($0.50/contract)
$500,000 (securities up to $500,000, cash up to $250,000)
Using ETFs and Mutual Funds
The main thing to remember is that the fund provider will charge an annual expense ratio — which is always expressed as a percentage. For example, you might be charged 0.2% — so a $10,000 investment would cost you $20 per year.
Some bond fund providers — such as Vanguard, allow you to invest directly. This isn’t always the cheapest option on the table, as you might get a more competitive rate at an online broker.
Directly From the US Government
If you’re looking to invest in bonds issued by the US government — you can make the purchase directly from the TreasuryDirect website. In doing so, you only need to meet a minimum investment of $100.
Your coupon payments will be reflected in your TreasuryDirect account, which is distributed every six months. You can also sell your US Treasury bonds before maturity directly on the TreasuryDirect website.
What Are the Best Strategies?
Like all investments, it’s best to have a strategy in mind when thinking about how to invest in bonds.
There are many such strategies utilized by experienced investors, such as:
- Ladder bond strategy: This strategy will see the investor buy multiple bonds of a similar nature (e.g., treasury bonds) at varying maturity dates. This risk-averse strategy is great for income-seeking investors that crave flexibility.
- Barbell bond strategy: This is another risk-averse strategy that will see the investor purchase a combination of short-term (maturity is often less than one year) and long-term (maturity is often more than 10 years) bonds. The idea here is that the shorter-term bonds carry the least amount of risk as they are less exposed to an unfavorable change in interest. The longer-term bonds carry more risk but offer a much greater rate of return.
- Bullet Bond Strategy: This strategy will see the investor purchase a large number of bonds – all of which have the same maturity date. The bonds will be purchased at different intervals – usually at least a year apart.
Benefits of Bonds
Here’s a breakdown of the main benefits of investing in bonds:
- Bonds are ideal for those seeking a fixed income. You will usually receive a coupon payment every six or 12 months until the bonds mature.
- Your future income is predictable as most bonds offer a fixed yield.
- Bonds come in various shapes and sizes, so you can choose an instrument that meets your financial goals and appetite for risk.
- Maturity dates run from a few months to several decades, so they are ideal for both short-term and long-term investors.
- Bonds can be a great way to hedge against other asset classes, such as stocks and currencies.
Risks of Bonds
Here’s a breakdown of the main risks and drawbacks of investing in bonds:
- Unless you are investing in US Treasuries, bonds can be illiquid. This means that you might not be able to offload them until they mature.
- Bonds are not risk-free. There is always the chance that the issuer will default on a coupon payment or worse, the principal.
- Bonds are particularly susceptible to changes in interest rates.
- Some bonds are difficult to get hold of if you are a retail investor. You might also find that minimum lot sizes are high.
Note: Bonds get graded by rating agencies such as Moody’s, Standard & Poor’s, and Fitch Ratings. These rating agencies publish simple grades on all debt issues.
FAQ About How to Invest in Bonds
We’ve found some of the most frequently asked questions regarding how to invest in bonds. Here are our answers.
How Do You Make Money With Bonds?
There are two ways in which you can make money from a bond investment. The most passive way is to buy bonds and collect your interest payment every six or 12 months until they mature.
As most bonds come with a fixed coupon rate, you’ll always know how much you’ll be receiving. The second option — which is best reserved for experienced traders – is to buy bonds and then sell them on the secondary market before they mature.
The idea here is to sell the bonds for more than you paid by offering them at a premium. This is achieved when the value of the bonds increases in the open market, largely because the risks of default have since increased.
When Is It a Good Time to Buy Bonds?
This depends on what your financial goals are. If you are simply looking for a passive way to invest and seek predictable, incoming cash flows — you can buy bonds at any given time.
With that said, if you’re looking to time the market well, many investors will buy bonds when inflation levels are declining. This is because when inflation falls, so do interest rates. In turn, this can lead to increasing bond prices.
Additionally, a good time to buy bonds is when the stock markets are going through a prolonged bear market. This allows you to hedge against falling stock prices.
In summary, many investors will allocate some of their portfolios to bonds.
Not only does this provide a predictable flow of income, but it can be a great way to hedge against the stock markets.
You should, however, consider bonds are never risk-free – especially outside of the US Treasury scene.
Additionally, not all bonds can be sold on a secondary market before maturity, so consider the opportunity risks, too.
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Kane is a highly-skilled researcher and writer with expertise in finance, trading, and cryptocurrencies. Academically, Kane holds a Bachelor’s Degree in Finance, a Master’s Degree in Financial Crime, and he is currently engaged in a Doctorate. He is passionate about researching the money laundering threats of the virtual economy — notably, cryptocurrencies and blockchain technology.