How to buy bonds is a question most investors have asked themselves. Understanding what bonds are, how to buy them and how to use them is critical for success in this popular investment strategy.
What Are Bonds?
Bonds are an asset class where the investor lends a government or business money for a set period, with the promise of repayment of that money plus interest. Unlike stocks, which are purchased shares of ownership in a company, bonds are the purchase of a company or public entity’s debt obligation. Considered a safer investment than stocks, bonds also earn a lower return on your investment. For example, long-term government bonds historically earn around 5% in annual returns. Stocks are more volatile but have earned an average of between 7% and 10% each year.
The date a bond is first sold is called its issue date, and the date its principal is due is called its maturity date. So bonds are “issued,” and then they “mature.” Between these two dates, the issuer makes regular interest payments called coupons. Bond interest is called a coupon because before electronic trading, investors were given paper certificates when they purchased a bond and attached to each certificate were coupons for interest payments.
When the date on a coupon arrived, the investor would clip the coupon and deposit it into a bank account or mail it to the issuer for a check, depending on the terms of the bond. Today, coupon payments on U.S. bonds are often directly deposited into the investor’s bank or brokerage account. They’re typically made every six months, depending on when the bond was issued. So, for example, a bond first sold on December 15 pays interest on June 15 and December 15 every year until maturity.
The people who purchase a bond receive interest payments during the bond’s term (or for as long as they hold the bond) at the bond’s stated interest rate. When the bond matures (the term of the bond expires), the company pays back the bondholder the bond’s face value.
U.S. government bonds are considered the safest investment. Also known as Treasurys, these bonds are backed by the “full faith and credit” of the United States. Bonds issued by states and local governments generally are considered the next-safest investment, followed by corporate bonds. Bonds are graded by rating agencies, such as Moody’s and Standard & Poor’s; the higher the rating, the lower the risk that the borrower will default.
How to Buy Bonds
There are different ways to buy bonds. Some of them are through:
You can buy new bonds through the U.S. Treasury Department 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.
You can buy bonds 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.
You can buy bonds through a mutual fund or an exchange-traded 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 and Specifically How to Buy Bonds
Many companies, including the federal government, issue and sell bonds. How safe a bond is largely depends on who the bond issuer is. Some companies that issue bonds are:
How to buy bonds from corporations? Corporations issue corporate bonds. Corporate bonds’ safety varies a lot, depending on the company’s credit ratings. Some companies issue investment-grade corporate bonds, which have lower interest rates because of the safety of the investment. Companies with lesser credit ratings issue 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.
How to buy bonds from agencies? Government-sponsored enterprises, like Fannie Mae or Freddie Mac, issue agency bonds. Agency bonds aren’t 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.
How to buy bonds from municipalities? States, cities and local governments issue municipal bonds. The safety of these bonds varies. Sometimes, a municipal bond may be insured. In that case, an insurance company will have to make good on the bond, if the municipality defaults.
How to buy bonds from the U.S. government? 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 can happen 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 note before buying bonds:
The biggest factor to look out for is whether the company can pay its bonds. You can figure this out by looking at the credit ratings issued by rating 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, expressed in years, that shows 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 must hold on to your bond until its set maturity date.
You should always know 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 the bond you’re looking to buy or bonds with similar maturities, credit ratings and interest rates.
Tips on Purchasing the Right Bonds
There are three main reasons investors buy bonds. Some investors use bonds to create a steady stream of income. Since a bond's coupon payments are guaranteed, investors know when and how much they'll receive. This also makes bonds useful for funding specific future liabilities, such as retirement or college. A bond’s principal repayment can be timed to coincide with major expenses or purchases.
Or you can use bonds to reduce your portfolio's overall risk. Bonds have a low correlation to stocks, meaning their value is often up when stocks are down and vice versa. Because of this, high-quality bonds, such as high-grade corporate issues and especially U.S. government bonds, can be very useful for diversifying the risks of owning stocks. Adding bonds to a portfolio can significantly dampen volatility and losses of value.
Bonds can also protect a portfolio from an economic downturn. When the economy slows, falling inflation increases the purchasing power of future bond payments. Likewise, because a slowing economy reduces stock returns, investors often flock to bonds in such times, driving up prices.
How to buy bonds can be a complicated process for the new investor. Buying one means you are lending out your money and you expect to be paid back with interest. They are also called fixed-income securities because the cash flow from them is fixed. The key reason to purchase one is to diversify your portfolio. The issuers are governments and corporations. There is an inverse relationship between the price and the yield. When the price goes up, yield goes down and vice versa. There is also an inverse relationship between interest rates and price. When interest rates rise, their price in the market falls, and vice versa.
Investing in bonds isn’t for everybody. Bonds are considered to be a safer alternative to stocks in the short term. They are less volatile, meaning there will be fewer swings. The stock market can be too risky for some so many investors adopt a diversification strategy with lower risk investments. Bonds pay a regular interest rate (income) but rarely go up in value as much as stocks, ETFs or mutual funds. Retirees are popular investors in bonds, as they many times have a shorter investment horizon. Take some of these tips to make the correct investment call for you.