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What Are Bonds?

Bonds are a relatively low risk way to diversify your portfolio. Learn how they work, as well as about the pros and cons of investing in them.

As you build your investment portfolio, it’s always a good idea to diversify. This means spreading your funds around to different types of securities. One major type is a bond, which is a loan you extend to a company that it must pay back later, with interest.

Bonds can be a smart investment because they provide you with a regular stream of cash flow. They also tend to be lower risk than other securities, such as stocks. In this article, you’ll learn how they work, the various types, benefits and disadvantages, as well as how to get started. We’ll also answer frequently asked questions about the asset.

How Bonds Work

A bond is, in essence, an IOU from a company to you. More specifically, you lend money to a company and they, in return, promise to pay you back over a specific period, plus interest. Keep in mind that, with this type of security, you have no ownership stake in the firm. However, this also means your returns won’t be impacted nearly as much by its performance.

Typically, the issuer (company or entity you invest in) pays you interest via coupon payments, which allow you a steady stream of income. These are often semiannual, or twice a year. Once the bond reaches its “maturity date,” you’ll receive an amount equal to its “face value,” or your initial investment.

The maturity date, as well as how much it’ll pay you in interest depends on the one you select. They can take anywhere from months to decades to mature. As an example, let’s say you purchased a three-year bond for a $2,000 face value at a 5% coupon rate. In this case, you’d receive $100 each year, or, with the initial investment, $2,300 total.

How a Stock Is Different

As mentioned earlier, a bond gives you no ownership stake in a company. Rather, you receive a promise that it’ll pay you back after the duration of the maturity term, plus interest. Stocks, on the other hand, allow you to own a part of the firm. However, this also means you’re at the mercy of its performance in the market.

Because the market performance doesn’t typically dictate a bond’s return, they’re not as risky as an individual stock. However, they’re also not as likely to give you the high rewards that the latter might. Investors turn to them for a low-risk way to create additional income, as well as diversify their portfolio.

Types of Bonds

There are several types of bonds you can buy. Typically, they differ based on the issuer, or how it works, such as coupon rate or term length. Here are the most common varieties you’ll find:

  • Corporate. Firms issue these types of bonds to raise additional capital. Depending on the financial health and outlook of the company, these may be riskier than other types. 
  • Municipal. Local governing bodies issue bonds to fund various projects around the city or town, such as building structures or conducting repairs. Interest from these is often exempt from federal income tax. And, if you’re a resident of the city, you may also be able to avoid state and local taxes.
  • Treasury. The U.S. Treasury also issues bonds to fund government activities and projects. They’re widely regarded as one of the safest investments because you’re relying on the full faith and credit of the U.S. government. However, because they’re so safe, you shouldn’t expect high returns.
  • Agency. These are bonds issued by Government Sponsored Enterprises (GSEs) and Federal Government Agencies. Risk can vary depending on the issuer. For instance, GSEs carry more risk than Federal Government Agencies, which have the full faith and credit of the U.S. backing them.
  • International. It’s always an option to look abroad for more diversification. With international bonds, you can do that. However, watch out for extra risks, like foreign exchange rates and potentially different regulations (which or may not be on your side).
  • Convertible. These allow you to convert your bonds into shares of a company. Firms with low credit and a high growth potential, such as startups, offer these.
  • Zero-coupon. With these, you won’t receive any interest payments. Rather, you’ll buy in at a discounted price. Then, once it matures, you’ll receive the full face value, netting a profit. These are a way to get into debt securities with less money, but still see a return when it’s all said and done.

Pros and Cons

Bonds are often a low-risk investment for modest rewards. With this in mind, they come with some key benefits if you’re looking to diversify your portfolio. However, there are some disadvantages to consider as well, such as the potentially low returns. Below is a snapshot of the pros and cons of investing in them:

Pros

  • Ability to create fixed income. With a bond, you can receive income in the form of interest payments.
  • Diversification. Bonds are a relatively low-risk way to diversify your portfolio.
  • Less risk. While they’re not without their risks, bonds aren’t subject to volatile market performance as stocks are. So, it’s not as easy to lose big by investing in them.

Cons

  • Small returns. With less risk comes lower rewards. Bonds typically don’t yield as much because they typically only pay you the face value, plus interest.
  • Credit risk. When you buy a bond from a company, there’s always a chance that they won’t be able to pay you, resulting in a default. This could cause you to lose your initial investment.
  • Inflation. You may end up losing money if a bond’s interest rate doesn’t keep up with inflation.
  • Interest rate considerations. As interest rates go up, the value of bonds goes down. If you sell before it matures while rates are high, you could lose money.

How to Invest in Bonds

You can invest in bonds through a few different methods. In some cases, you can buy directly from issuers, such as with the U.S. Treasury through a TreasuryDirect account. However, for most other types, including corporate, you’ll need to use a brokerage firm, such as Fidelity, Vanguard, and Charles Schwab.

Before you buy, you should do your research and pick bonds that make sense for you. Here are considerations you’ll want to make before investing:

  • Your personal goals
  • The type of bond you want to invest in, i.e., maturity period, interest rate, issuer, etc.
  • Credit rating and overall health of a company – you can check via credit reporting firms, such as Moody’s, Fitch, or S&P.
  • Diversification – you may want to test different types of bonds to see what garners the best returns.

Keep in mind that it can be difficult for retail clients to buy bonds on the IPO market. Large institutional investors typically buy up large amounts of them, making them less accessible for individuals.

Finally, if you’re unsure about whether you should get into bonds or the types you should buy, it’s always a good idea to talk to a financial advisor. They can help you identify wise investments that fit your goals. You can find a vetted professional by using a convenient matching tool, which will connect you with up to three in your area.

What to Watch Out For

Fraud is an unfortunate risk of investing in bonds. Whenever you buy from a corporate issuer, make sure you’re doing your due diligence to protect yourself at all costs. The best way you can do this is by checking if the company is registered with the SEC with its EDGAR search tool

Another resource to protect yourself is the Electronic Municipal Market Access, or EMMA for short. Municipal securities must file annual financial information with the Municipal Securities Rulemaking Board (MSRB). So, if you’re considering investing in a municipal bond, be sure to use EMMA to see if its information pops up. You may want to steer clear if nothing comes up!

You should also take care to evaluate a company or organization’s credit rating before buying a bond. If a firm is unable to pay you the face value once your security matures, you may lose your investment. Services like Moody’s, Fitch, and S&P can help you evaluate an organization’s credit. Also, keep in mind that when you invest in government bonds (Federal Agency or Treasury), they have the full faith and credit of the U.S. backing them, so they’re a much lower risk.

Frequently Asked Questions

Can I trade bonds?

A bond’s value will fluctuate during the maturity period, so it may be tempting to buy and sell them. You can do so; however, it can come with risks. If you sell at the wrong time, you may end up earning an amount below the face value, losing you money.

How do I buy U.S. bonds?

You can do so through TreasuryDirect, the U.S. marketplace for buying and redeeming government bonds.

How do I buy corporate bonds?

To buy corporate bonds (or others, such as municipal or international), you’ll need to use a brokerage firm, such as Fidelity or Vanguard.

Do bonds make money?

Bonds can make you money through interest payments, plus a payout of the face value at the end of the maturity period. For example, if you purchase a $1,000 bond at a 6% interest rate with a three-year maturity term, you’ll net $180. 

You also have the option of selling before maturity. However, make sure that you’re getting above or at face value so you don’t take a loss on your investment.