You hear a lot about investing in stocks, but bonds deserve some love, too. Investing in bonds can help grow your wealth and balance your portfolio.
What are bonds and how do they work?
A bond is a loan to a company or government that pays back a fixed rate of return. Companies and governments issue bonds to raise money.
Bonds work by paying back a regular amount to the investor, and are referred to as a type of fixed-income security. A bond's rate is fixed at the time of the bond purchase, and interest is paid to investors on a regular basis — monthly, quarterly, semiannually or annually — for the life of the bond.
Many financial planners advocate investing in bonds because of their lower volatility and relative safety compared with stocks. But not all bonds are equal, and investors need some strategies for investing in bonds and building their bond allocation the right way.
How to invest in bonds: Bonds vs. bond funds
Individual bonds typically are sold in $1,000 increments, so diversifying a bond portfolio can be difficult because it’s pricey. It can be less expensive to buy bond funds, such as mutual funds or exchange-traded funds. Here’s a quick explainer of the differences between bonds and bond funds.
Individual bonds. If you want to buy bonds directly from the U.S. government, or you want to buy bonds from a specific company, you can buy individual bonds. You can buy company bonds from an online broker. You’ll be buying from other investors looking to sell. You may also be able to receive a discount off an individual bond’s face value by buying a bond directly from the underwriting investment bank in an initial bond offering. The Financial Industry Regulatory Authority (FINRA), a government-authorized nonprofit, oversees broker-dealers and posts bond transaction prices as the data becomes available.
For Treasury bonds, the federal government has set up a program on the Treasury Direct website so investors can buy directly without having to pay a fee to a broker or other middleman.
Bond funds. If you want to purchase small pieces of several bonds from many issuers in a single transaction, bond funds are a great option, and you can buy bond funds through an online broker as well. Index funds and ETFs are a kind of mutual fund that track an index. Some funds are focused on short-, medium-, or long-term bonds, or provide exposure to certain industries or markets. A fund may be a wise choice for individual investors because it provides immediate diversification and you don’t have to buy in large increments. (Learn how to buy bond ETFs.)
These funds can provide diversified exposure to the bond types you want, and you can mix and match bond ETFs even if you can’t invest a lot of money at a time.
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What are the different types of bonds?
Here’s a sampling of some major bond types, from least to most risky.
Federal government bonds. In the U.S., bonds issued by the federal government are considered among the safest, such that the interest rate is very low. The government also issues “zero coupon bonds” that are sold at a discount to their face value and then are redeemable at face value on maturity, but they don’t pay any cash interest.
Municipal bonds, or munis. Issued by state and local governments, municipal bonds are among the lowest-yielding bonds on offer, but they help make up for that by being non-taxable. Indeed, the after-tax yield on a muni may end up being higher than on a higher-yielding bond, especially for investors in high-tax states.
Investment-grade corporate bonds. These bonds are issued by companies with good to excellent credit ratings, as determined by the ratings agencies. Because they’re safer borrowers, they’ll pay lower interest rates than poorly rated bonds but typically more than the U.S. government pays.
High-yield bonds. Formerly known as junk bonds, high-yield bonds offer a larger payout than typical investment-grade bonds, due to their perceived riskiness.
Are bonds a good investment?
Bonds have advantages and disadvantages, just like any other investment.
Benefits of investing in bonds
Bonds are relatively safe. Bonds can create a balancing force within an investment portfolio: If you have a majority invested in stocks, adding bonds can diversify your assets and lower your overall risk. And while bonds do carry some risk, they are generally less risky than stocks.
They’re also a form of fixed-income. Bonds pay interest at regular, predictable rates and intervals. For retirees or other individuals who like the idea of receiving regular income, bonds can be a solid asset to own.
Risks of investing in bonds
With safety comes lower interest rates. Long-term government bonds have historically earned about 5% in average annual returns, while the stock market has historically returned 10% annually on average. And even though there is typically less risk when you invest in bonds over stocks, bonds are not risk-free.
For example, there is always a chance you’ll have difficulty selling a bond you own, particularly if interest rates go up. The bond issuer may not be able to pay the investor the interest and/or principal they owe on time, which is called default risk. Inflation can also reduce your purchasing power over time, making the fixed income you receive from the bond less valuable as time goes on.
Can I lose money investing in bonds?
Yes. Bond prices tend to move countercyclically. As the economy heats up, interest rates rise, and bond prices fall. As the economy cools, interest rates fall, and bond prices rise. So if you sell a bond when interest rates are lower than they were when you purchased it, you may be able to make money. But if you sell when interest rates are higher, you may lose money.
How much of my portfolio should I invest in bonds?
One typical standard for midlife savers is a 30% allocation in bonds, with that figure going up as they approach retirement. Bonds provide regular income to investors, and their prices generally don't fluctuate too much relative to more volatile stocks, ensuring more stable income and assets during retirement.
But what kinds of bonds should you buy? When filling out that part of your portfolio, you’ll want to avoid a huge pitfall that could cost you big money.
» Ready to get started? How to buy bonds
What should I watch out for?
The biggest trap when buying bonds is going for the largest yields, the bonds that pay out the most.
The two most important risks for a bond investor are whether the bond’s issuer pays back the bond with interest and whether overall interest rates rise. If an issuer can't repay the bond or rates rise, the bond will become less valuable. When the price of a bond declines, its yield — the percentage of its price that it pays to investors — goes up.
In each risk case, a high-yielding bond may forecast trouble. Investors may have discounted a bond expecting to collect less than the full face value from the issuer, so it’s cheaper and yields more.
A bond may also yield more because it has a long duration, maybe 10, 20 or 30 years. These bonds offer a higher yield as compensation to investors for locking their money up for so long. But bonds with such long maturities are the most affected when overall interest rates rise, and they can lose substantial value over that time. While investors can recover the full face value at maturity, if the issuer can pay it, that may take a very long time for a long-term bond, 30 years in the case of some government bonds. You don’t want to be trapped in this situation.
It's good to examine high-yield bonds carefully or consider having professionals do it for you.