Financial Lit: Investing in Bonds

If you're interested in portfolio diversification or stable growth, researching the types of bonds available can be a good investment strategy. Entities needing to raise money will sell these fixed-income securities that have a set term and offer you interest payments through the maturity date. While putting your money in the stock market can offer higher yields, choosing suitable bonds can mean lower risk and less volatility. Here's what you should know before becoming a bondholder.

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Buying a bond means loaning a corporation or government a specific amount of money for a period of time. In return, the bond issuer rewards you with a coupon that usually means it will pay interest every ​six months​ until the bond reaches maturity, when you'll then receive the principal back. Depending on the type of bond, the interest rate may be fixed, or it could be variable and adjust as inflation rates rise.

To understand bond prices, consider that the bond's face value, or par value, refers to the principal amount you'll be due when the term ends. While you might pay this exact amount to buy the bond, it could also be valued differently based on current market conditions and sell at either a discount or premium. For example, a $5,000 bond selling for less at $4,500 would be discounted, while the same $5,000 bond selling for $5,200 would be at a premium. In either case, you'd still get the $5,000 upon maturity.

Rating agencies such as Standard & Poor's and Moody's provide credit ratings for bond issuers. These bond ratings help to differentiate between investment-grade and junk bonds to help you make wiser investment decisions. For example, a rating of AAA would indicate the highest bond rating, while a rating of C or D would indicate a very weak choice.

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You have some variety when it comes to how you invest in bonds. First, you can invest in individual bonds that work as previously discussed. On the other hand, you can invest in bond funds (bond mutual funds) that are professionally managed and offer more diversification in exchange for more fluctuating distributions.

Bonds can help avoid some of the volatility that comes with stocks but still earn a return – although with lower interest rates – that's better than putting your money in a regular savings account or not investing at all.

You'll also choose from types of bonds such as federal government bonds, corporate bonds and municipal bonds. For example, the U.S. government offers U.S. Treasury bonds with maturity dates up to ​30 years​ and essentially no default risk. Corporate bonds help companies with everything from paying debt to buying facilities and can have various risk levels. On the other hand, municipal bonds (munis) help finance local or state government projects and typically come with the benefit of tax-free earnings for investors.

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Especially when you invest in government bonds, you can get the benefit of a stable investment with a low default risk. Bonds can help avoid some of the volatility that comes with stocks but still earn a return – although with lower interest rates – that's better than putting your money in a regular savings account or not investing at all. In addition, when you invest in fixed-rate bonds, you can be advantaged if market rates fall since you'll still get the original rate.

At the same time, you should consider some bond risks. For example, credit risk and default risk especially make corporate bonds risky, so it's crucial to research bond ratings. Interest rate risk can affect any bond's performance, and bond rates might not keep up with inflation. Also, consider liquidity since needing to redeem your bond early can mean both losing some money and having to find someone willing to buy your bond.

Bond investors need to go to different sources to buy bonds depending on the type. For example, if you want U.S. Treasury bonds, it's simple since you can just go to the government's Treasury Direct website. You can then either buy these federal bonds outright or participate in an auction.

But if you want corporate or municipal bonds, you'll first set up a brokerage account for the transaction and then look for the bond you wish to purchase. With a broker's help, you can seek new issue municipal and corporate bonds or find them sold by other investors on the secondary bond market. You can expect to pay commissions with these bonds.

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