Investing in Bonds for Beginners
Everything you need to know about bonds.
Bonds refer to a type of financial instrument that represents a loan obligation between borrowers and investors. The borrowers are usually either corporate bodies or the government.
To put it simply, say, Company ABC needs $1 million to buy a machine. So, how they do it is that they put out a bunch of bonds, say, each valued at $1,000. What investors will do now is they’ll have a look at these bonds — see if the interest payment is worth it or not — and they’ll buy these bonds.
Say Mr. A bought 2 units of these bonds, he’ll pay $2,000, and wait for his interest payments that will constantly flow in for like, 7 years. It won’t be much, but it’s constant and (almost) guaranteed.
You can trade bonds by selling them to other investors, it’s like telling the borrower “from this day onwards no need to pay to me, pay to this dude instead”. This is another way of making money since bonds’ prices move up and down too.
In this article, we wouldn’t look into the technicality of a bond, but if you’re interested in that, have a look into our other writeup: Bond Yields, Maturity, and Interest Rate.
How many types of bonds are there?
In the American context, there are generally three basic types of bonds: U.S. Treasury, municipal, and corporate.
U.S. Treasury bond refers to bonds that are issued by the U.S. government. How it goes is that the government would usually auction these bonds to fund government operations.
The period of interest repayment varies, but it usually would be around 10 years or more. These bonds are considered very safe because essentially the one who owes you money is the U.S. government. It’s quite hard for them to refuse to pay you back.
As the usual rule of thumb goes, low risk equals low return, the U.S. Treasury bonds are the most popular type of bonds, but the interest rate is relatively low.
The best part about this type of bond is that the proceeds are tax-free.
Municipal bonds are nearly the same, but these bonds are issued by state and local governments to raise some cash for their respective jurisdictions, perhaps for things like road construction, schools, public amenities, and so on.
Municipal bonds are riskier than U.S. Treasury bonds, but they are less risky compared to corporate bonds. It’s unlikely for them to default on the payments, but local governments can go bankrupt. Correspondingly, the interest rate offered is also generally more interesting compared to U.S. Treasury bonds.
This bond can be categorized under two basic categories, General Obligation Bonds (GOB) and Revenue Bonds. GOB refers to bonds secured by the issuer (state/local government) in totality, while revenue bonds are where the payment of interest is made from the revenue generated by the project funded by the bonds.
Corporate bonds are bonds that are issued by companies in order to fund any of said business’ capital investment or expansion. This type of fund is generally the riskiest among the three since there are many ways for a company to go wrong/
However, there are different ‘risk grades for corporate bonds. The higher the risk, the higher the possible returns are. You can find the risk grade for corporate bonds as follows.
What should you consider when buying bonds?
Credit rating: It’s like a report card for the bond. You want to look for bonds that have a good rating. The lower the rating, the higher the yield, but also the higher the risk of the issuer defaulting on their debt. So, if you’re feeling risky, go for those junk bonds.
Issuer: Check on the bond issuer. You don’t want to buy a bond from a company that’s headed for some financial trouble. That’s like buying a ticket to one of the largest submarines ever made — the Titanic.
Market conditions: Market conditions will affect your bonds. Say, If interest rates are rising, the value of current bond issues will likely decline, and vice-versa. It’s not very straightforward as many elements in the market can affect the value of your bond.
Maturity date: That’s when the bond expires and you get your money back (with interest). You don’t want to buy a bond that’s going to expire next week, that’s like buying a rotten apple.
Fees: Nobody likes fees. So, make sure you know what fees you’re paying before you buy that bond. Your brokers aren’t saints and the fee structures are rarely very transparent. Be sure to properly know how much you’re paying.
Tax treatment: There are two things in life that we’re sure of — death and taxes, except if you invest in some bonds, like the government bonds which provide for tax exemption for interests derived from it.
How to buy bonds?
Buy directly (Treasury Bond)
For Treasury Bonds, you can buy them directly from the U.S. Treasury via TreasuryDirect. This is a good way to avoid paying much more in commissions and fees to your broker.
Do keep note that via TreasuryDirect, you’ll have to keep a bond for 45 days after purchasing it before you can sell or transfer it.
Another way of buying bonds is through OTC means. Of course, it’s online nowadays. However, the downside of any OTC transaction is that you’ll need to pay your brokers. So, be sure to look for yourselves good brokers with good customer service.
Bond mutual funds
You can also opt to pool your money with a bunch of other people in a mutual fund. A mutual fund will invest the pooled money in multiple bonds while distributing the yields accordingly.
The downside of mutual funds is that bonds are usually money-back-guaranteed, which means that you’re most likely to get your money back (with interest) if you invest in an individual bond.
The thing about a fund is that it’s a basket of multiple bonds, so if one bond performs badly, then your whole portfolio will take the hit.
That, and the fact that a fund manager manages a fund — it’s good if you don’t have time to watch over your investments, but you don’t really have the flexibility of choosing which bonds to buy and which not to.
Exchange-traded funds (ETFs)
ETFs are like mutual funds. It’s almost exactly like mutual funds, apart from the fact that ETFs can be bought in exchange. So, anywhere you buy your stocks, be it some brokerage app or what, you can probably find ETFs there too. Just look for a bond ETF.
Pros and Cons
- Short-term stability.
- Steady Income
- Less volatile
- Often used as portfolio diversification.
- You’d feel like you contributed to society (if you invest in municipal bonds).
- Tend to underperform in a long term.
- Incomes are relatively low.
- It takes a while until you can see that sweet cash — well, quite a long while.
- Bonds are a financial instrument used to represent a loan obligation between borrower and investor.
- The borrower here is usually a corporation or government entity.
- There are generally three types of bonds: U.S. Treasury, municipal, and corporate. When buying bonds, investors should consider credit rating, issuer, market conditions, maturity date, fees, and tax treatment.
- Bonds can be bought directly from the Treasury, over-the-counter through a broker, or through bond mutual funds & ETFs.
- Although bonds are generally considered low-risk investments, investors should carefully consider their investment goals and risk tolerance before investing.
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None of the material above or on our website is to be construed as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. Investors should carefully consider if the security and/or product is suitable for them in view of their entire investment portfolio. All investing involves risks, including the possible loss of money invested, and past performance does not guarantee future performance.