Stocks and bonds are often discussed interchangeably. That’s mostly because where you have one in a portfolio, you have the other – or at least you should.
Bonds are stocks’ more conservative cousins.
They’re added to a portfolio to provide a measure of safety of principal, as well as a steady stream of interest income.
Since they’re part of any well-constructed portfolio, it’s important to learn how to invest in bonds.
What Are Bonds?
Bonds are debt securities issued by corporations and governments. They usually come in denominations of between $100 and $1,000, which the issuer guarantees to pay when the bond matures. Between now and then, a fixed rate of interest will be paid on the security.
A government or corporation can issue bonds for a variety of purposes. Governments typically issue them to finance capital improvements, such as the building of roads, bridges, seaports, and power plants. They can also issue them to finance general budget operations, which is much more typical.
Corporations may also borrow for short-term purposes, such as increasing cash or purchasing inventory. But the proceeds may also be used for capital projects, like purchasing plants and equipment, office buildings, land, or even other companies.
Technically speaking, “bonds” refers to long-term debt securities, such as those with maturities greater than 10 years. However, in recent years it’s become a catchall phrase to describe all types of fixed income investments, including US Treasury bills and even certificates of deposit.
Loosely speaking, bonds describe the fixed income portion of your portfolio.
Depending on the issuer of the bond (government or corporation), both the denominations and the frequency of interest payments will vary.
For example, corporate bonds are usually issued in minimum denominations of $1,000 and pay interest semiannually. The same may be true for municipal bonds, issued by state and local governments. But US Treasury securities typically come in denominations of as little as $25 to $100 and have several methods for paying interest.
The Benefits of Investing in Bonds
As mentioned in the introduction, the basic purpose of bonds is to add stability to your portfolio by reducing risk. Since stocks can both rise and fall in price, the more stable value of bonds act as a counter.
During times when stock prices are falling, bond prices remain relatively constant and reduce the overall risk in your portfolio.
For example, let’s say your portfolio is comprised of 50% stocks and 50% bonds. Should stocks fall by 20%, your overall portfolio will drop by just 10%. That’s because only half your portfolio is in stocks.
Bonds also have the benefit of paying interest. This adds an element of stable income to your portfolio. And as a general rule, interest paid on bonds is higher than what you can get in savings accounts and bank certificates of deposit.
Unlike dividends, the interest rate on bonds can’t be reduced or eliminated. Since the bond is a legally contractual obligation of the issuer, they must pay interest according to the terms of the security. Even if the issuer is losing money, and can’t pay dividends, they’ll still pay interest on their bonds.
Potential for capital appreciation. Though investors don’t normally buy bonds for this purpose, they do have this potential. If interest rates fall after you purchase the bond, the value of the bond is likely to rise.
For example, if you purchase a 20-year $1,000 corporate bond at an interest rate of 5%, the bond will pay interest of $50 per year. If prevailing rates fall to 4%, the value of the bond may rise to $1,250. That’s because the annual interest of $50 will represent a 4% return at that value.
This describes the inverse relationship between bonds and interest rates that we’ll discuss in greater detail below.
The Risks of Investing in Bonds
The above benefits notwithstanding, bonds do involve a measure of risk.
The most obvious is the potential for issuer default. If the company that issues the bonds goes out of business, the bonds will become worthless. This is certainly a possibility with corporate bonds, and while it’s theoretically possible for states and local governments to default on municipal bonds, there’s not much history of it.
By contrast, US Treasury securities are considered impervious to default. That’s because the US government can tax, borrow, or print money to pay both the interest and principal on their securities. As well, US Treasury securities are considered the safest investments in the world, are traded globally, and have a very liquid market.
Interest rate risk. This is the risk inherent to all bonds – including US Treasury bonds. In the previous section, we describe how bonds can experience capital appreciation if prevailing interest rates fall after you purchase the bond. But of the inverse relationship between interest rates and bonds, if interest rates rise, bond prices fall.
For example, let’s say a corporation issues a $1,000 20-year bond with an interest rate of 4%. The bond will pay $40 in annual interest. But if prevailing rates go up to 5%, the market value of the bond may fall to $800. At that market price, the $40 in annual interest would represent a 5% return.
It’s important to understand that this is essentially a temporary market situation, though it can last for many years in extreme circumstances. However, if you hold the bond until maturity, you’ll be paid the full-face amount.
The Different Varieties of Bonds
There are three major types of bonds available to investors – corporate bonds, municipal bonds, and US Treasury securities.
These are debt securities issued by public corporations and traded on national exchanges. They can be purchased through investment brokerage firms for a very small fee. A typical bond term is 20 years, and they’re purchased in denominations of $1,000. A broker, however, may have a required minimum 10 bond purchase, or $10,000.
They can be purchased as either newly issued bonds, or as existing bonds. If you purchase existing bonds, the price may be higher or lower than $1,000, depending on current market rates compared to the coupon rate the bond is paying.
If you do purchase corporate bonds, you’ll need to understand the risk level of the securities you’re purchasing. You can obtain that information through major bond rating agencies, including:
There are two basic classes of bonds. The first is known as investment grade bonds. These are issues rated by the agencies as AAA, AA, A or BBB. AAA is the highest rated bonds, while BBB is the lowest rated in the class.
The second category is what is known as high yield bonds, so-called because they pay higher interest than investment grade bonds, due to their lower ratings (BB and below).
Just a few years ago they were commonly referred to as junk bonds because of their higher likelihood of default. But apparently, the investment community isn’t comfortable with that label, and converted it to the more positive sounding “high yield bonds”. But don’t be fooled by the fancy repackaging. These bonds may pay higher yields than investment grade bonds, but they also carry a much greater risk of default.
They’re still junk bonds, even if they aren’t called that any more.
These are bonds issued by states, counties, municipalities, and their agencies. The major advantage they have is that interest on the bonds is tax exempt from federal income tax. They’re also exempt from state income tax if you live in the state where the bonds are issued (which is commonly referred to as “double tax-free”).
Because of their tax-exempt status, they’re best held in taxable investment accounts. They’re not necessary in tax-deferred accounts, like IRAs, because the benefit of tax exemption doesn’t apply.
Similar to corporate bonds, municipal bonds can be purchased through investment brokerage firms. You should also check the bond ratings from the three rating agencies listed above, as they vary even on municipal bonds. This is true even though the incidence of municipal bond default is extremely rare.
US Treasury Securities
If you’re familiar with the national debt, this is how the government funds that obligation. Because the securities are issued by the US government, they’re considered the safest of all bonds. They can be purchased through the US Treasury portal, Treasury Direct, or through an investment broker.
Though Treasury securities make up a big segment of what is commonly referred to as bonds, they actually represent a large number of different security types.
- Treasury bills. These have maturities of between a few days and 52 weeks. They’re available in denominations of $100 but are sold at a discount. For example, you might purchase a bill for $98, and be repaid $100 at the end of the term. The $2 difference will be the interest paid.
- Treasury notes. These have maturities ranging from 2 to 10 years and are purchased in denominations of $100. They pay interest every six months, then face value at maturity.
- Treasury bonds. These securities have terms of 30 years and are also available in denominations of $100. Like notes, they pay interest every six months and the face amount at maturity.
- Treasury Inflation Protected Securities (TIPS). These securities are issued with terms of five, 10, and 30 years, and in denominations of $100. They also pay interest twice each year, but they come with a twist. The principal value of the security is adjusted based on the Consumer Price Index (CPI). If the CPI increases, so does the principal value of the security. If it decreases, so does the principal value of the security. However, if you hold TIPS until maturity, you’ll be paid the greater of the face amount or the principle adjusted value.
- Savings bonds. These include EE and E bonds that can be purchased for as little as $25, and earn interest for 30 years. There are also I bonds, which work the same, except they pay additional principal based on the CPI, just like TIPS.
Technically speaking, only Treasury bonds are true bonds. But treasuries of all denominations are frequently described collectively as bonds. Also, be aware that interest from US Treasury securities is exempt from state income tax.
Interest on the securities fluctuate daily, and you can check them at Treasury Resource Center page. The screenshot below shows an example of the rates as of early April 2019:
How and Where to Buy Bonds
Bonds can be purchased either individually, or through bond funds.
As discussed above, corporate and municipal bonds can be purchased through investment brokers, while US Treasury securities can be purchased through Treasury Direct. For the most part, individual bonds are best used by those with large portfolios. That will provide an opportunity to diversify among many different bond issues.
Bond funds are a way to diversify over many different bond issues, but with a lot less money. But another major advantage is that you can choose specific types of bonds or bond terms.
For example, you can choose a fund that invests strictly in the US and/or foreign bonds. You can also go with a municipal bond fund, even one that specializes in your state. You can also go with a fund that invests only in US treasuries. Some bond funds offer a mix of corporate and municipal bonds and US Treasury securities.
But that’s just the beginning. You can also choose an investment-grade bond fund or a high-yield bond fund. Some funds also specialize in bonds of certain maturities. For example, one might specialize in bonds with maturities of greater than 20 years. Another might focus on those maturing in five years or less.
The advantage with bond funds is that you can choose specifically how you want to invest in bonds, as well as the specific amount. They’re perfect for smaller portfolios.
How Much Should You Invest in Bonds?
Should you invest in bonds, and if so house much? This is an ongoing debate. As a general rule, it really depends on your risk tolerance. The lower your risk tolerance, the higher the percentage of your portfolio that should be invested in bonds. If you have a high risk tolerance, the bond allocation should be smaller. If you invest with a robo-advisor, they’ll make this determination for you, and set a specific bond allocation in your portfolio.
But if you don’t invest through a robo-advisor, there is a rule of thumb you can use. It’s 120 minus your age. It actually calculates the amount of your portfolio that should be in stocks, based on your age.
For example, if you’re 30 years old, 90% of your portfolio (120 – 30) should be invested in stocks, leaving 10% for bonds. If you’re 50 years old, 70% of your portfolio (120 – 50) should be invested in stocks, with the remaining 30% in bonds.
But remember, that’s just the rule of thumb. You should adjust that based on your own risk tolerance, and how soon you expect the need the funds from your portfolio.
That’s the basic summary of how to invest in bonds. Everyone should have at least some in their portfolio.