Investing in bonds is a type of investment in which investors essentially loan money to bond issuers, which are usually corporations or federal, state, or government agencies such as mortgage lenders Fannie Mae or Freddie Mac. Generally investors buy bonds for two main reasons, income and return of principal.
In the short-term bonds are generally less volatile and less risky than stocks, but not as risky as cash equivalents investments such as CDs or money market accounts. As a result bonds returns tend to be higher than those of cash equivalents but not as high a stock returns over the long term.
Bonds Investing Terminology
Before investing in bonds familiarized yourself with some basic bond terminology.
Par value: the face value price of the bond that the investor will eventually receive back its principal.
Coupon rate: the interest rate at the bond pays. For example, to bond with a par value $1000 in annual coupon rate of 9% of pay $90 a year.
Maturity date: the date on which the bond issuer will return the principle to the lender and stop making interest payments. The length of time until the bonds maturity date, also known as the bonds term, can be anywhere from less than a year to 30 years. Usually, the longer the term, the higher the coupon rate.
Callability: Callable bonds give the issuer the right to recall the bond, payback principle, and stop paying the interest at a point in time before the maturity date. All corporate and state or local government bonds specify whether they can be called and how soon they can be called. Federal bonds are never callable.
Like stocks, bonds are bought and sold through brokers and brokerage houses, both of which usually at a markup of 2-5% to the par value of the bonds they sell so a par value of $100 might sell for $102.
Bonds are often grouped based on their terms. This could be short-term, bonds with terms of 0 to 3 years, intermediate term, bonds with terms of 3 to 10 years, and long-term, those bonds with terms of 10 years or more.
On the surface, bonds seem like a great deal. You get paid to lend money, and then you get back all the money you lent. However, bonds do present to the unique types of risk, credit risk and interest rate risk.
The riskiness of a bond depends in part on the bond issuers credit worthiness, or the likelihood that the issuer will in fact make good on its promise to pay interest and return the investors principal. When you buy an individual bond, there’s rarely 100% guarantee that you will receive your interest payments and your principal. If a bond issuers suffers a major financial crisis, such as a bankruptcy, it may default or failed to meet its obligations to its investors.
Individual bonds have bond ratings that rank the credit worthiness of their issuers. The safest issuers have A ratings, such as A,AA, or AAA. For example, a AAA rating, the highest rating, suggested default risk of less than 1%. Riskier issues have ratings with B’s, C’s, or D’s. In general, the higher the bonds default risk the higher the coupon rate.
Bond prices move in the opposite direction of prevailing interest rates: when interest rates rise, bond prices fall, and vice versa. Bonds react this way because higher interest rates make bonds with coupon rate below prevailing interest rates less attractive to buyers.
The Most Common Types of Bonds
Of the many types of bonds in the market, the five most common are government bonds, municipal bonds, corporate bonds, TIPS in high-yield junk bonds.
Government bonds are bonds that are issued by local, state, or federal governments. Government bonds issued by the US government are called treasuries. The interest that treasuries pay is subject to federal income tax but is stay tax-free. There are three main types of treasuries. Treasury bills, treasury notes, in treasury bonds. Treasuries are considered very safe bonds with virtually no default risk. The debt of unstable foreign governments is similarly safe but carries currency risk, the prospect of a change in interest payments based on fluctuating currency rates.
Investing in Municipal bonds, also known as munis are bonds issued by state and local governments or government agencies. The interest rate the municipal bonds pay is not subject to federal tax. Municipal bonds are also state and local tax-free to investors who reside in the states or localities that issued the municipal bonds they own, which makes some municipal bonds triple tax-free, or entirely free from tax
Investing in Corporate bonds are bonds issued by corporations. Corporate bonds tend to have higher yields than government bonds and municipal bonds due to their higher risk of default. Companies go bankrupt more often than governments. Even so the bonds of many companies, especially AAA rated companies have a low default risk. In general, the higher a company’s credit rating, the lower the coupon rate of its bonds. All corporate bonds are subject to federal, state, and local taxes
TIPS or treasury inflation protected securities, are a special type of treasury note or bond that offers protection from inflation. Every year the government adjust the par value of these bonds based on the consumer price index, a measure of inflation.
High yield bonds or junk bonds are corporate bonds that have a high risk of default and therefore a high annual coupon rate, often in excess of 10%. Junk bonds are very risky and should be approached with great caution.
Like stocks, bonds can be purchased either individually or as part of the bond mutual funds or ETFs. They’ll bonds are an important part of virtually any investment portfolio, buying individual bonds takes a considerable time and effort and is usually best left to professionals. If you do want to try buying individual bonds, it is best to stick with treasuries. For most investors, though, the safest, cheapest, and easiest way to buy bonds is through bond mutual funds or ETFs