There are a number of ways to buy bonds: directly from the U.S. Government, via a bond fund or with the help of a broker. Before you make your purchase, it’s important to understand what types of bonds there are, and how much risk and reward each type carries. Bonds can be a good way to round out a diverse portfolio, but not all bonds are as straightforward and reliable as you might think. If you want help buying bonds or any other investments, consider working with a financial advisor.
How to Buy Bonds
If you’re interested in buying bonds, there are a few different options you have. However, not all sellers are equal, as they each offer specific types of bond investments that may or may not be what you’re looking for. For instance, buying through a brokerage lets you purchase very specific bonds. On the other hand, buying through a bond fund is less specific, but much more wide-ranging.
Here’s a breakdown of the three main methods for investing in the bond market:
Buying Bonds Through the U.S. Treasury Department
You can buy new Treasury bonds online by visiting Treasury Direct. To set up a Treasury Direct account, you must be 18 or older and legally competent. You will need a valid Social Security Number, a U.S. address and an account at a U.S. bank. The Treasury does not collect fees nor does it mark up the bond’s price.
Buying Bonds Through a Brokerage
Most online brokerages sell Treasury bonds, corporate bonds and municipal bonds. Brokers like Fidelity, Charles Schwab, E*TRADE and Merrill Edge offer extensive bond listings. However, the purchasing process through an online brokerage is nowhere near as straightforward as through Treasury Direct. Bond prices vary from brokerage to brokerage, thanks to transaction fees and markups or markdowns.
Buying Bonds Through a Mutual Fund or ETF
A bond fund is a good option if you don’t have the cash to spend on a diverse array of individual bonds. You often have to buy individual bonds in large, often pricey units. With a bond fund, you can get diversity for a lower cost. However, bond funds don’t have a set maturity like individual bonds, so you may see your interest payments vary and your income is not guaranteed.
Who Issues Bonds?
There are several categories of bond issuers, from companies on up to federal and state governments. How safe a bond is largely depends on who the bond issuer is. That’s because bonds are typically backed by the entity who issues it. Below is an overview of the usual bond types and issuers on the market:
Companies issue corporate bonds. Corporate bonds’ safety varies a lot, depending on the company’s credit ratings. Companies with excellent to low credit ratings issue investment-grade corporate bonds, which have lower interest rates because of the safety of the investment. Companies with lesser credit ratings high-yield bonds, or junk bonds. These bonds have higher interest rates to reflect that riskiness, so if the company makes good on the bond there’s a larger payout.
Government-sponsored enterprises like Fannie Mae or Freddie Mac issue agency bonds. Agency bonds aren’t quite as safe as Treasury bonds. However, because the agency bond issuers are guaranteed by the federal government these bonds are generally considered safer than even the safest corporate bonds.
States, cities and local governments issue municipal bonds. The safety of these bonds varies. In some instances, a municipal bond may be insured. In that case, an insurance company will have to make good on the bond if the municipal defaults.
The U.S. Treasury Department issues Treasury bonds. These bonds are the safest of the safe. Treasury bonds pay interest every six months until they mature, which happens in 30-year terms.
What to Watch Out for When Buying Bonds
Bond buying can be a tricky process. This is particularly true if you’re buying used bonds or if you aren’t buying a bond directly from the underwriter. To ensure you’re getting a good deal, here are the main things to take note of before buying a bond:
The biggest factor to look out for is whether the company can actually pay its bonds. You can figure this out by looking at the credit ratings issued by ratings agencies like Moody’s, Standard and Poor’s and Fitch. The safest rating, which goes to Treasury bonds, is AAA.
You should also note a bond’s duration, which Vanguard explains “represents a period of time, expressed in years, that indicates how long it will take an investor to recover the true price of a bond, considering the present value of its future interest payments and principal repayment.” A bond’s duration is an indicator of how sensitive the bond will be to changes in interest rates. A longer duration translates to greater fluctuation when interest rates change. When interest rates rise, the value of a bond falls.
If you want to ensure that you get your set interest rate and the full payout, you’ll need to hold onto your bond until its set maturity date.
You should always be aware of the fees that a brokerage can tack onto a bond’s cost if you aren’t buying directly from the underwriter. You can make sure you’re getting a fair deal by taking advantage of publicly available data on the pricing of bond you’re looking to buy, or bonds with similar maturities, credit ratings and interest rates.
Bonds vs. Stocks
Bonds are generally a far safer investment than stocks. This is because the future performance of a company is hard to predict, whereas the terms of bonds are much clearer. That doesn’t mean bonds are risk-free, though. There’s always the chance that a bond issuer will default and not pay the debt.
While bonds’ lesser risk diminishes the chances of unexpected failure, it also lowers the chances of unexpected success. Because a stock’s value varies after you buy it, you’ll always have the chance of seeing a stock’s value soar. This can’t happen with a bond.
Having a mix of bonds and stocks in your portfolio is a great way to take advantage of the benefits of diversification. In short, your portfolio will contain both the relative safety and stability of bonds, while taking potentially money-making risks with stocks.
Bonds might be a safer investment than stocks, but they’re certainly not foolproof. Be mindful of the bond issuer’s credit rating and the bond’s duration before putting money out. If you’re buying bonds from a brokerage, do your research to avoid excessive fees. Though it’s not advisable to build an entire portfolio of bonds, bonds can be a good passive investment to make while you manage riskier investments.
Tips for Building a Financial Portfolio
- A financial advisor can assess your entire financial situation and determine which investments are truly best for your portfolio. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Diversify. Don’t put all your eggs in one basket. The healthiest portfolio boasts a variety of investments across market categories. That way, if one of your investments suffers a downturn, your entire portfolio won’t suffer.
- Invest for the long term. You should avoid acquiring investments that you won’t want to keep for long. Instead, opt for investments that you’re confident will grow more valuable over time.
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