How to Invest in Bonds
Investing your money is a smart and efficient way to save up for long-term goals such as buying a home or retirement. Learning how to invest in stocks is also an effective means for short-term saving for life expenses like vacations or school tuition. Anyone who is interested in having a more secure future while earning a little bit of money in the meantime, should have an investment portfolio.
However, it’s important to realize that investing in itself isn’t enough. You also need to be diverse in what you invest in. In other words, “don’t put all of your eggs in one basket.” A great way to diversify your investment portfolio is to learn how to invest in bonds.
What are Bonds?
Bonds are loans given by lenders to governments, cities and large companies or corporations. In return, lenders are given recurring interest payments until the term of the loan has ended. Once the term has ended, the “issuer” (borrower) will pay the principal back in full.
While the exact terms of each bond will vary, the underlying groundwork is similar. Most bonds will be a “fixed-rate.” As a lender, you will receive a fixed “coupon” (percentage rate for interest payments) over a fixed timeframe.
Most interest payments are done semi-annually, for the life of the bond.
For example, if you bought a bond of $50 with a 10% coupon and 2-year maturity date, you would receive payments of $2.50 twice a year ($5 total) for 2 years. Once finished, you would receive your $50 (principal) back.
A 10% coupon or 2-year maturity date is just an example. Bonds can have coupons as low as .5% or as high or higher than 10%. Bonds can also mature in as little as a day, or they won’t mature for 30 years. Some bonds may even be “floating-rate-bonds”, which will have a coupon that adjusts to market conditions.
Many variables are factored into what makes up the terms. One of these factors is who the issuers are, so let’s look at the entities you can buy bonds from.
Bond issuers will come in many shapes and sizes. They will play a large role in determining how much money you might make, as well as the risk you take to make that money.
Government bonds are the lowest risk bond to get involved with. This is because a government is unlikely to go bankrupt, because a government creates and charge taxes. Bonds issued by the government will come in one of the following forms.
Bills: Bills are bonds that have a maturity date of less than one year.
Notes: These bonds have a maturity date ranging from 1 to 10 years.
Bonds: Bonds have a maturity date of 10 years or more.
Because of how secure government bonds are (low-risk), you’ll likely see a much smaller coupon than you would if you were issued a bond from a corporation or company.
Also known as “Munis,” Municipal bonds are bonds issued by a city or town. This type of bonds is also low-risk, because the likeliness of a city going bankrupt is slim.
Municipal bonds are also free of federal tax. Because of this, the coupon that a lender receives tends to be smaller.
Corporate bonds are the riskiest type of bond to purchase. This is because there is a higher chance of a corporation or company going bankrupt. If so, the corporation won’t be able to pay back principals and you’ll lose your investment.
Because of this, you will be given a higher coupon, to compensate for the risk you take. This coupon will vary due to a company’s credit rating. The better a company’s credit score, the lower your coupon will be, because they are considered a lesser risk than a company with a poorer credit score.
Zero Coupon bonds are simply as the name suggests, “no coupons.” This type of bond does not pay regular interest payments, but the bond can be bought at a price less than the “par” value, while the face value will be paid when the bond matures. The profit is made from the difference of what you pay for the bond and what you receive when the bond matures.
How to Buy Bonds
When you’re ready to purchase a bond, you can do so using one of the following methods.
Brokers will likely be the most expensive route, when looking to purchase a bond. It is common for most brokers to require a minimum which can be in the neighborhood of $5,000, give or take. Also, despite that you may be told that your bond is “commission free,” many brokers tack on a fee and/or commission to the top of the bond itself.
When buying through a broker, it is always a good idea to research the market first to get an idea of what your bond is worth and what you should be paying.
If you have a brokerage account, you can purchase bonds through different banks or credit unions. A couple of financial institutions that can aid you in buying bonds would be Wells Fargo and Bank of America. You will have to have an account and will pay fees that vary depending on market conditions.
Direct through Government
To cut out the middleman entirely, you can visit treasurydirect.gov. Here you will pay no fees, because all transfers and payments are done electronically.
Investing in Bonds
Investing in bonds, or anything, for that matter, is simply no different than investing in yourself and your future. Bonds are a great way to invest, because their fluctuation is much milder when compared to stocks. This means a more stable income for you.