When you invest in a bond, you are loaning money to that organization in exchange for regular interest payments and repayment of your principal (or amount you initially paid) at a future date—potentially offering diversification to an investment portfolio. Here's what you need to know about how to invest in bonds.
Things to keep in mind when considering bonds
Understanding the following terms and how bonds work could help you feel more confident about investing in them.
- Issuer: The company, government, or agency funding its operations via bonds is known as the bond issuer. The bond is part of the organization's promise to pay back all its debts.
- Maturity date: This is the date when the bond issuer will repay the full amount that you loaned it when you purchased the bond.
- Face value: Also known as "par value," the face value describes the amount of money the bondholder will be paid on the maturity date. Generally, you can expect to pay a different amount to purchase the bond than its face value.
- Coupon rate: This term refers to the annual interest rate, expressed as a percentage, that the issuer pays to the bondholder.
- Bond credit rating: Ratings agencies like Standard & Poor's, Moody's, and Fitch assign bond ratings, like a grade, on the financial health of the issuer, which can change over time.
- Callability: Issuers may want to repay bonds early, in a process known as a call back or recall. They might do this if interest rates fall enough so that they can save money by issuing new bonds at lower rates. In general, only callable bonds can be recalled prior to the maturity date.
- Yield: The percentage of return an investor receives based on the amount invested or on the current market value of holdings. It is a function of both the price paid and the coupon, and expressed as an annual percentage rate.
Decide whether you want to buy individual bonds or bond funds
Individual bond pros
- Interest payments offer a reliable income stream.
- Investors receive the par value on the maturity date, provided the bond isn't called ahead of time.
- There's no market risk to investors who hold the bond until the maturity date, provided the issuer does not default.
Individual bond cons
- Investors must manage their own investment strategy.
- The bond price for individual investors may be higher than the price offered to institutional investors.
- Individual bonds may require a larger investment because an investor may consider buying many bonds from multiple issuers and maturities to help ensure diversification.
- If a callable bond is called prior to maturity, regular interest payments would stop and an investor may not be able to find a similar rate on a new bond.
Bond fund pros
- Funds may offer broader diversification with a smaller investment.
- They may come with lower prices, as funds usually pay institutional investor prices for individual bonds.
- Bond funds are professionally managed.
Bond fund cons
- They come with management fees.
- The net asset value (NAV), or the value of one share of the fund, is based on the value of all the bonds in it and typically fluctuates daily.
- Funds may offer less predictable returns because they are made up of multiple bonds (which may change as the fund manager buys and sells bonds) with different interest rates and payment schedules. Most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
Figure out what type of bonds you want to invest in
There are several different bond types you can choose from. Here are common ones:
Treasury bonds Issued by the US Treasury to pay for government activities and to service the national debt, Treasury bonds are backed by the "full faith and credit of the United States government," which means they are considered very low risk. Yields are generally lower than those of other bonds, but income is not subject to state or local taxes.
Agency/GSE bonds Agency bonds are either issued or backed by a US government department or agency. In either case, agency bonds are guaranteed by the federal government. The Government National Mortgage Association (GNMA) is one commonly known backer of agency bonds.
Government-sponsored enterprise bonds (GSE bonds) are issued by privately owned entities chartered by Congress. GSEs perform public functions like the provision of affordable loans in particular sectors of the economy, such as housing or agriculture. GSE bonds are not guaranteed by the federal government. Issuers include the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae).
Interest income from some agency bonds is exempt from state and local taxes.
Municipal bonds Issued by municipalities like states, counties, cities, or towns, municipal bonds help pay for public works projects (like infrastructure) or municipal government activities. In most cases, municipal bonds, often called "munis," are federal income tax-exempt as well as exempt from state and local taxes if the bondholder lives in the issuing state.
Corporate bonds Corporations issue bonds to pay for equipment, expansion, construction, and more. Because companies may be more likely to default than governments, corporate bonds typically pose a higher risk than the above 3 types and often have higher yields as a result. Expect to pay federal income and state taxes on interest earned as dividends and on capital gains if you sell the bond for more than you paid for it prior to its maturity date.
Bond funds may contain any combination of the above.
Pick an investment account that matches your goals
Depending on your investment goals, it may make sense to hold the bonds you buy in different types of accounts. In general, bonds are a way to diversify your holdings. Because they throw off interest payments that are taxed at ordinary income rates, they might be better candidates for tax-shielded accounts. Munis, which are generally federally tax-exempt, may make sense for taxable accounts. Consult with a financial professional and tax advisor if you need help determining your strategy.
Saving for retirement With some tax-advantaged accounts, you don't have to pay taxes on the income generated by bonds until you make withdrawals in retirement or sometimes, not at all. That means bonds may make sense in those accounts, especially the closer you are to retirement when you may be more conservative and interested in preserving capital through bonds. Examples of tax-advantaged accounts include:
- Employer-sponsored retirement plans, like a 401(k), 403(b), or 457(b) plan
- Individual retirement accounts (IRAs)
- Roth IRAs (with Roth accounts, withdrawals are tax-free after certain conditions are met)
Saving for a child Depending on your goals, 529s, Roth IRAs for Kids, UGMA (Uniform Gifts to Minors Act) and UTMA (Uniform Transfers to Minors Act) custodial accounts could make sense when investing in bonds. The first 2 are tax-advantaged and could help manage bonds' taxable income. The last 2, while taxable, are more tax-efficient than adult accounts because the earnings can be tax-exempt, taxed at the child's usually lower rate, or, above a certain threshold, taxed at the parent's income tax rate.
Saving for health expenses If you are eligible for a health savings account (HSA), you can use it to pay for qualified medical expenses or as another retirement account after age 65. Consider how you'll use this account when deciding on your bond allocation.
Investing when you've maxed out tax-advantaged accounts Because you pay taxes on gains in a taxable brokerage account, income-generating bonds are considered tax-inefficient here unless they're tax-exempt munis.
Figure out how much you want to invest in bonds
When investing in bonds, consider such factors as your overall asset allocation, investment objectives, time horizon, and risk tolerance. Bonds tend to be lower-risk investments than stocks, but remember some bonds are riskier than others, and historically, bonds have a lower return than stocks.
Purchase your bonds or bond funds
You can buy bonds and bond funds in a brokerage account. With individual bonds, you can either purchase new-issue bonds or from other investors looking to offload their bonds through the secondary market. You may be able to buy a bond for a lower price than what the seller paid and possibly make money if you hold it until maturity, but when investing in bonds, yield is more important than price. While you could buy a bond below par, if the coupon is low there might be higher-yielding bonds available. Make sure you understand issuer risk and credit ratings.
Check in on your bond investments
Bonds may feel like a set-it-and-forget-it investment, but it's important to check in regularly to make sure your investments are on track to meet your goals, decide if you want to hold or sell your bonds, plan for income taxes from interest and potential capital gains, and rebalance your portfolio if necessary.