Figuring out how to buy bonds is a deceptively complicated process. Before you make your purchase, it’s important to understand what types of bonds there are, and how much risk and reward each bond carries. Bonds can be a good way to round out a diverse portfolio, but not all bonds are as straightforward and reliable as the ones your grandma gave you for graduation.
How to Buy Bonds
There are a few main ways to buy bonds. However, not all sellers are equal.
- 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.
- Through a brokerage. Most online brokerages sell Treasury bonds, corporate bonds and municipal bonds. Brokers like Fidelity, Charles Schwab, E*Trade and TD Ameritrade 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.
- Through a mutual fund or an exchange-traded fund (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 the federal government. How safe a bond is largely depends on who the bond issuer is.
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 Look Out for When Buying Bonds
Bond buying can be a tricky process, particularly if you’re buying used bonds or if you aren’t buying a bond directly from the underwriter. To make sure you’re getting a good deal, here are the main things to take note of before buying bonds.
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, assigned 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.
How Do Bonds Compare to Stocks?
Bonds are generally considered a far safer investment than stocks. “Unlike a stock where you’re not sure of future cash flows of the company, with bonds you know exactly what they’re going to be,” Rick Ferri, an advisor at Portfolio Solutions, told Money.
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 diminishes the chances of unexpected success. Because a stock’s value is not locked in when you buy it, you’ll always have the chance of seeing a stock’s value soar.
Having a mix of bonds and stocks in your portfolio is a good way to take advantage of 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. 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
- 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.
- Keep investment expenses low. As in the case of buying bonds, fees can add up fast.
- And last but not least, turn to a financial advisor for guidance. A financial advisor can assess your entire financial situation and determine which investments are truly best for your portfolio. A matching tool like SmartAsset’s can help you find a person to work with to meet your needs. First you answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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