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Bonds are relatively low-risk investments that consist of lending money to a company or a government agency in return for fixed interest payments. They typically offer predictable returns, lower volatility than equities and are excellent ways to diversify your portfolio.
However, there are different types of bonds. Depending on your investment goals and risk tolerance, some bonds might be more appropriate than others for your strategy.
Here’s a guide on the different types of bonds, how they work and how to buy them.
What are bonds?
Bonds are debt obligations of a corporation or the government. Essentially, they are a loan that investors give bond issuers in exchange for a fixed interest rate. Corporations typically use bonds to raise money for expansion or capital improvements, whereas government entities may use them to finance general operations, programs or municipal projects.
Types of bonds
There are different types of bonds, each with its own characteristics, advantages and inherent risks.
U.S. Treasury bonds
Treasurys are debt-securities issued by the U.S. Department of the Treasury to fund government expenses and operations. These include bills, notes and bonds.
Treasurys are considered some of the safest fixed-income securities because they are backed by the full credit of the government. Since they are a direct obligation of the federal government, there is confidence in its ability to avoid default and issue new debt to ensure interest payments and the repayment of principal (the original amount) at maturity.
The Treasury Department also offers savings bonds with variable interest rates. Rates for Series I bonds are leveraged to inflation, meaning they are adjusted every six months according to how high or low the Consumer Price Index is.
Series EE bonds have fixed rates for the first 20 years, but the rate can be adjusted thereafter. The government also guarantees that they will double in value over 20 years.
Municipal bonds, also known as “munis” or tax-exempt bonds, are issued by local governments (states, cities or counties), and other non-federal government agencies. These bonds are usually used to finance public projects, programs, services and general operations.
There are two main types of municipal bonds:
- General obligation bonds: These are used to fund programs and projects that don’t generate income, like building public infrastructure. These bonds are backed by the full faith and credit and taxing power of the issuing municipality. This means that the municipality must use tax revenues and take necessary measures to repay bondholders.
- Revenue bonds: These are used to finance municipal projects, like toll roads, utility services, hospitals and airports. These bonds are backed by the revenue generated by the specific project. Revenue bonds are considered riskier than general obligation bonds because their repayment depends on the success and revenue generation of the project itself.
One significant perk of municipal bonds is that they’re generally tax free at the federal level and may also be exempt from state and local tax if you live in the issuing state or municipality. This makes them a good option for investors in a higher tax bracket.
Corporate bonds are debt securities issued by publicly traded or private companies who need capital or operating cash to fund various operations and initiatives, such as acquisitions, building new facilities, investing in research and development (R&D) or refinancing existing debts.
Unlike buying common stocks, corporate bonds don’t give you equity in a company nor voting rights. You won’t receive any dividends, either. Instead, you’re giving the company a long-term loan in exchange for fixed semi-annual interest payments and the repayment of principal at maturity.
Corporate bonds generally offer higher rates of return than government bonds, but also involve additional risks. For instance, corporate bonds are subject to the financial stability of the issuing company and can be vulnerable to changes in profitability, credit rating or economic downturns.
Bondholders also face credit or default risk if the company fails to make timely payments or goes bankrupt, and compared to Treasury or municipal bonds, corporate bonds can present liquidity issues.
However, secured corporate bonds are considered a legal obligation and have precedence over the payment of dividends on common stocks. In a bankruptcy, bondholders will generally receive a better treatment than stockholders or general creditors.
Bond funds are mutual funds or exchange-traded funds (ETFs) that invest in a diversified portfolio of bonds. These are run by professional portfolio managers who make research-based decisions according to the fund’s objectives and investment strategy.
One downside to bond funds is that they charge expense ratios that investors must pay annually. Expense ratios are used to cover professional management fees, administrative expenses and operating costs.
However, unlike investing in individual bonds, bond funds can provide greater portfolio diversification because they generally hold bonds from various sectors and issuers with varying maturities. This exposure to a wide range of bonds can help reduce the impact that a single bond’s performance can have on a portfolio’s return.
Short-term vs. long-term bonds
Bonds also have differing maturity dates, and can be classified as short-, medium- or long-term securities.
Short-term bonds have maturity dates within one to four years from the time of purchase. However, there are numerous Treasurys available with maturities of less than one year. For instance, Treasury bills, or T-bills, have maturity dates of four, 13, 26 and 52 weeks. These short-term maturities allow you to access your funds sooner.
Medium-term or intermediate bonds offer maturities ranging from two to 10 years. Treasurys in this range are referred to as T-notes and are offered in two, three, five, seven and 10 year terms.
Long-term bonds have maturity periods of 10 years or more. Generally, these bonds offer higher yields than short-term bonds to compensate for the increased risk and extended duration of the investment. Treasurys in this range are referred to as T-bonds and are offered in 20- and 30-year terms.
Because they tie your money up for longer periods of time compared to short- and medium-term bonds, long-term bonds are more likely to increase in value if interest rates decline after their issuance. The opposite is also true: If interest rates increase, the value of bonds tend to decrease. However, this doesn’t apply to Treasurys, which have fixed-rate terms.
How do bonds work?
Bonds are financial instruments that represent debt. When you buy a bond, you’re lending money to the bond issuer — typically the government, a municipality or a corporation.
The issuer then uses the money to fund part of its operations and pays you a predetermined fixed interest rate until the bond reaches its maturity date. At maturity, you would receive the face value (or the amount invested), in addition to any remaining interest payments.
One exception to this is shorter-dated T-bills, which are sold at a discount (i.e., the face value or “par” value less the interest rate). At the date of maturity, you are paid the par value.
Because the bond market can be complex, it’s important you understand the following key features and characteristics:
- Coupon rate: the annual interest rate the issuer promises to pay bondholders, expressed as a percentage. For example, if a bond with a face value of $1,000 has a 6% coupon rate, it means that you would receive annual coupon payments of $60 until the bond matures.
- Coupon payments: the periodic interest payments bondholders receive, typically semi-annually or annually. Following the previous example, if a bond’s annual coupon payment is $60, it would pay half that amount ($30) twice a year if it were semi-annually.
- Face value (or par value): the amount the bond will be worth at maturity.
- Issue price: the price at which a new issue bond is initially sold. In many cases, it can be equal to the bond’s face value.
- Market value: the price at which a particular bond is currently trading in the secondary market. The bond market price can be different from the bond’s face value, and can trade either at above or below face value.
- Maturity date: the date when the issuer is supposed to repay you the bond’s face value. For instance, if you purchase a bond with a face value of $1,000, you would expect to receive interest payments during the life of the bond and the bond’s face value at maturity.
Where to buy bonds
There are several ways to buy bonds. The three most common options include:
Online brokerages provide convenient, easy-to-use platforms to buy and sell multiple investment products, like stocks, ETFs, options and bonds. Some brokerage firms, like Fidelity Investments and TD Ameritrade, offer access to different bond types, letting you buy municipal, Treasury and corporate bonds directly from their trading platforms.
Mutual funds and ETFs
Instead of buying individual bonds, you can buy bond mutual funds or bond ETFs. These funds generally include a mix of corporate, municipal or government bonds.
You can buy shares of bond ETFs and mutual funds through online brokerages, investment companies, financial advisors or other financial institutions that offer access to exchange-traded products (ETPs).
Treasury securities are available over the internet through the Treasury Direct website. There you can create an account and buy Treasury bills, notes and bonds, and savings bonds directly from the U.S. government at auctions held numerous times each month and in amounts of $100. Unlike buying bonds from brokerage firms, purchases made through Treasury Direct are commission free.
How to buy bonds
Most bonds can be purchased online through a broker, as long as it provides access to this type of investment. If you already have a brokerage account, you can use the search tool to explore bonds available through that platform.
If you're new to investing, you can create an investment account within a few minutes. The best online trading platforms offer seamless set up processes and typically just require you to fill out some personal information and link a bank account to add funds.
There could be extra steps required depending on the type of bond. Below we discuss some further options and key factors to consider when buying some bonds.
How to buy Treasury bonds
Treasury bonds can be bought directly from the U.S. Department of Treasury using the TreasuryDirect platform. In addition to Treasury bills, notes and bonds, the platform also offers Treasury Inflation-Protected Securities (TIPS), I bonds and EE bonds.
Opening a TreasuryDirect account is easy. You just need to choose the type of account you want and provide personal information, including your Social Security number, address and a checking or savings account.
Once your account is set up, you’ll be able to purchase and schedule reinvestments through the BuyDirect page. There you can select the type of marketable securities you want and submit a bid for. Keep in mind that all Treasurys, including bonds, have to be purchased in increments of $100, up to $10 million.
There are two type of bids:
- Noncompetitive bid: You agree to accept the bond price determined at auction and are guaranteed to receive the bond in the full amount you want.
- Competitive bid: You specify the discount rate, yield or discount margin you’re willing to accept. Depending on the auction results, your bid may be accepted or rejected. To make competitive bids, you must use a bank, brokerage firm or dealer.
How to buy corporate bonds
Corporate bonds can be purchased through a brokerage, bank or other financial institutions, including popular online brokerages. You can also buy corporate bonds through bond funds, like corporate bond ETFs.
When you buy bonds from a brokerage, you’re purchasing them on the secondary market. This means the bonds you buy are generally owned by other investors who want to sell their bonds before maturity. The price for these bonds can fluctuate depending on supply and demand, and from factors like changing interest rates or maturity dates.
In addition, brokerages frequently include markups on bond purchases and charge commission fees.
What are bond rating agencies?
One important factor to consider when investing in corporate bonds is the creditworthiness of the issuing company. Credit rating agencies like Moody’s, Standard & Poor’s and Fitch assess the financial stability and credit risk of corporations and rate their bonds.
Higher-rated bonds, like those with ratings of AAA to BBB- (or Aaa to Baa3) indicate lower credit risk, while lower-rated bonds, such as those with ratings of BB+ (or Ba1) and lower indicate higher credit risk.
Depending on their bond rating, they are grouped into investment-grade or non-investment grade bonds (also called “junk,” speculative or high-yield corporate bonds). Investment-grade bonds are generally safer and more stable, whereas junk bonds have a greater default risk.
Summary of How to buy bonds
- Bonds are debt securities that both government agencies or corporations use to raise money and in exchange they offer individual investors a fixed interest rate.
- Bond investing is one way of diversifying an investment portfolio because they are relatively safe and provide predictable returns.
- There are different types of bonds, including: municipal bonds, Treasury bonds, corporate bonds and alternatives like bond funds.
- Bond funds typically offer greater diversification because they let you invest in a well-diversified bond portfolio that includes bonds from multiple sectors and with different maturities, but which also charge expense ratios.
- Bonds can be purchased through online brokerages, via bond funds and directly from the U.S. Department of the Treasury through TreasuryDirect.gov.
- Before you invest in bonds, it’s important to understand the basics of how they work, their key features and the terminology associated with them, like coupon payments, coupon rates and par value.
- When investing in corporate bonds, consider the creditworthiness of the issuing company and the bond’s rating — check reputable credit agencies like Moody’s, Standard & Poor’s and Fitch.