How to Invest in Bonds: Predictable Returns With Low Risk
Whether you’re a new investor or a seasoned investor, having a balanced portfolio is crucial to minimizing your risk over time.
Some people make the mistake of putting all their money in stocks.
Diversification is a better plan, though.
Bonds are low-risk investments with predictable returns that can help diversify a portfolio filled with stocks.
Or, bonds can be used as part of an income investing strategy.
Regardless of your investing mindset and risk tolerance, find out how bonds can be important investments for you.
What Are Bonds?
Bonds are a type of asset that involves lending money to either a business or the government for a specific length of time.
Some investors like bonds because they pay a fixed interest rate annually.
Once the bond matures, the issuer repays its original value.
Bond terms vary depending on the type of bond. Some bonds mature after one year. Other bonds don’t mature until after 10, 20, or 30 years.
For many, bonds provide a much safer way to invest compared to stocks. This doesn’t mean that bonds are without risks.
For the most part, bonds are safe because they help balance out an investment portfolio.
Bonds and stocks typically have an inverse relationship.
The price of bonds usually decreases when stock prices rise, and vice versa.
Bonds, however, are generally safer than stocks.
With bonds, a promise of repayment is backed by the insurer.
And historically speaking, the bond market experiences less volatility compared to the stock market.
Unfortunately, bonds have a lower rate of return over time compared to the stock market.
So while a bond might earn 3 percent in annual returns, the stock market might offer a return up to 10 percent annually.
Another thing to keep in mind:
The quality of a bond is based on whether the issuer can pay investors their interest and principal.
There’s always the possibility of a bond issuer being unable to meet their repayment obligations. If so, you’ll receive less income from the bond.
Bonds also have liquidity risks, which occurs when you’re unable to find a buyer for your bond.
And sometimes, the rate of inflation can outpace the amount a bond pays out. If this happens, your purchasing power decreases.
Overall, though, bonds are a great fixed-income security to include in your investment portfolio.
The good news:
You can choose between different types of bonds.
What Are Different Types of Bonds?
Here’s a look at several types of bonds to reach your investment and financial goals.
1. Corporate bonds
Corporate bonds are those issued by a company.
Companies will use bonds to raise revenue, and then pay investors interest until the bond matures.
Once the bond matures, the company agrees to repay the original amount of the loan.
Some companies issue bonds when they need funds to expand, build a new structure, etc. Getting funds from investors can speed these projects.
Keep in mind:
Buying a corporate bond doesn’t give you ownership in the company.
2. Municipal bonds
Municipal bonds are those issued by local and state governments.
These bonds are often issued to raise money for local projects.
These projects might include building hospitals, fixing roadways, improving schools, and enhancing other infrastructure within a city or state. Bond terms vary depending on the corporation.
The best part:
You don’t pay taxes on the interest. This includes both federal and state taxes.
The downside is that municipal bonds typically pay lower rates compared to some corporate bonds.
You can choose a bond term as little as one to three years, or as long as 10 years.
3. U.S. government bonds
Bonds backed by the U.S. federal government are one of the safest types of bonds.
It’s a solid investment and you’re almost always guaranteed an annual return and full repayment of your original investment.
The downside, though, is that U.S. Treasury bonds tend to have a lower interest rate.
Before investing in Treasury bonds, understand that these aren’t short-term bonds. They have terms of either 20 or 30 years.
4. Bond ETFs
These are bonds that trade on an exchange.
They offer safe, predictable returns, but ETFs don’t have a maturity date. So you must sell to cash out.
The good news is that bond ETFs pay out interest on a more frequent basis — usually monthly instead of semi-annually or annually.
5. Bond mutual funds
Mutual funds refer to the pooling of investor money. This money is then used to buy securities. In the case of bond mutual funds, these are mutual funds that invests in bonds.
This offers another way to diversify your portfolio. And like other types of bonds, you’ll earn regular income from interest and repayment of your investment upon maturity.
Similar to ETFs, bond mutual funds don’t have a maturity date. Again, you must sell the bond to cash out.
Why Invest in Bonds?
Bonds are an excellent investment strategy to achieve your investing goals.
The most common reasons to invest in bonds include:
1. Less risk
Bonds tend to be less volatile than the stock market. So there’s a lower risk of losing your original investment.
Bonds are also attractive because of the promise of repayment of the original investment at maturity.
This is a top reason why some investors choose this asset class in their portfolio.
Although other types of investments can offer a higher return, a portfolio composed of mostly risky investments can also result in big losses during a market downturn.
Diversification, on the other hand, balances out the risk and softens the economic blow.
So while it’s good to put your money in riskier investments, you also want investments that can’t withstand turbulent market conditions.
3. Capital preservation
Investing is risky, and sometimes, you can lose all or most of your money.
So it’s smart to choose investment strategies that also protect your money and preserve your capital.
Bonds achieve this because you’ll get back your principal at maturity. This provides a measure of peace of mind.
4. Income generation
If you’re looking for an investment strategy that provides income at regular intervals, bonds are a great choice.
Getting regular fixed-income payouts can help supplement your income.
Some bonds pay their investors semi-annually or annually. But there are also bonds that pay interest payments on a monthly basis.
5. Invest in your community
A lesser-known benefit of investing in bonds is the ability to invest in your community.
When you purchase municipal bonds either through your state or city, the local government uses your investment to improve your community.
Where Can You Buy Bonds?
If you’re looking to diversify and add bonds to your investment portfolio, here’s how to buy them.
1. U.S. Treasury Department
To get bonds issued by the U.S. federal government, you can purchase these Treasury bonds online.
You’ll need to visit Treasury Direct and set up an account before buying your bonds. A few things to know, you must be at least 18 years or older. You must also have a U.S. address, a U.S. bank account, and a Social Security number.
One benefit of buying through the Treasury is that there isn’t a bond markup.
2. Brokerage firm
Another option is to open an online account with a brokerage firm.
Make sure that the brokerage firm sells the type of bonds you’re interested in buying.
Typically, you can buy different types of bonds through an online brokerage firm. These include Treasury bonds, corporate bonds, municipal bonds, ETFs, and bond mutual funds.
You’ll need to complete an application with the brokerage firm, fund your account, and then make your bond purchase.
Before opening up an account, make sure you compare commission structures and other fees among different firms.
Be mindful that you'll also pay a bond markup when buying through a brokerage firm.
To get started, you must be at least 18 years old.
You’ll need to provide basic information about yourself. This includes your Social Security number, address, and date of birth.
Building an investment portfolio is a great way to stay ahead of inflation, build wealth, and meet other financial goals.
But it’s important to diversify your portfolio and choose investments of different risk levels.
Bond assets are a great addition to your portfolio. You can earn a fixed amount of income at regular intervals and balance out your risk.