Beginner's Guide to Bond Investing

As an individual investor, you have many options for investments that you can put your hard-earned money into, but how can you know which ones are right for you?

According to the Securities Industry and Financial Markets Association (SIFMA), the bond market is estimated to be close to $120 trillion worldwide and around $45 trillion for the U.S. market, which means there is a lot of opportunities depending on your individual goals, risk tolerance and allocation strategy.

However, with that said, learning how to invest in bonds can feel overwhelming. From learning about the pros and cons of bonds, yields, funds, pricing and types it can be a lot to take in. That’s why we want to address the numerous challenges and questions beginning investors may have when starting their wealth-building process.

This AAII guide outlines the key steps needed to begin investing in bonds. Continue reading to get a full overview on how to invest in bonds like a pro—and learn how to fund your future financial goals in the process.

What Is the Bond Market?

The bond market is where debts are bought and sold in different forms such as bonds, notes and bills. Unlike stocks, most bonds are traded over the counter between broker-dealers, not on exchanges.

It’s important to understand the two segments to the bond marketplace: the primary market and the secondary market. The primary bond market deals with “new debt” between the issuer and the borrower. The secondary bond market deals with debt that has been on the public market but is now being shuffled around. Bonds, notes and bills on the secondary market can be purchased from a broker or brokerage and held in pension funds, mutual funds or life insurance policies. It’s crucial to understand the different areas of the bond market before you choose what type of bond you may be interested in investing in.

Investors can buy individual bonds through a broker or directly from an issuing government entity. Whether you’re exploring how to buy municipal bonds, corporate bonds or Treasuries, the basics of buying an individual bond remain the same: You can purchase them as new issues or on the secondary market.

What Is a Bond?

A bond is type of marketable security that acts as a loan to a company or government. This type of “IOU” pays investors a fixed rate of return over a specific time frame—also known as fixed income. Bonds represent the debts of issuers, from companies or governments. When these debts accrue, they are sliced up and sold to investors in smaller units in the form of bonds.

Unlike stocks where you have ownership rights as a shareholder of the company you choose to invest in, bonds represent a loan from the purchaser to the issuer. There are many different types of bonds as well as variances in their maturity, quality and yield.

What Are Bond Yields?

A bond yield is the return an investor will receive. A bond’s coupon rate or yield is the interest rate of a bond stated as a percentage of its face value. The coupon is fixed when the bond is issued. The easiest way to calculate a bond’s coupon yield is to use the following formula: coupon amount ÷ face value of bond.

Additionally, bond yield can refer to its current dollar price in relation to its overall cash flow. A bond’s cash flow consists of coupon payments and return. Called current yield, this number is not fixed and will change with the price.

A key takeaway from understanding bond yield is that a bond’s price and its yield are inversely related, which means that as the bond’s price increases, its yield will go down, and vice versa.

Types of Bonds

The type of bond you choose to invest in depends on who is issuing the bonds in the first place, such as the U.S. government and foreign bodies, financial institutions, cities and corporations. A few different types of bonds include:

• Corporate bonds: issued by companies and businesses who’d rather issue a bond than take a loan to fund a project
• Municipal bonds: issued by states and municipalities and typically fund infrastructure or local projects
• U.S. Treasury bonds: issued by the U.S. government and fund national expenditures
• International and emerging markets bonds: issued in a domestic market by a foreign entity as a means of raising capital
• Agency bonds: issued by government-affiliated organizations

This tradeable debt is often more liquid and less volatile than other ways to take out loans; therefore, bonds are an efficient way for entities to raise capital. The most common type of bond that investors use are municipal bonds, often referred to as “muni” bonds.

How Do Bonds Work?

Before you invest in any marketable security, you should understand how it works. Bonds are issued by governments, corporations, institutions and other entities when they want to raise money instead of taking out a loan. By buying a bond, the purchaser provides a loan to the issuer, which the issuer agrees to pay back at face value on a specific date. In this contract, the issuer also agrees to pay the purchaser periodic interest payments, which is constitutes the investment return.

You’ll want to look at the bonds’ maturity, tax status and coupon rate and yield before investing in them.

Bond maturity refers to the date when the principal or par amount of the bond is paid back to the investor and the bond issuer’s obligation ends. Bond maturities are classified as short term, intermediate term and long term.

While you may hear that you have to pay taxes on the majority of bonds, some government and municipal bonds are tax-exempt, so you’ll want to make sure you put them in the right type of investment account. If you choose taxable bonds, you may want to hold them in a tax-deferred account such as a traditional IRA.

Varieties of Bonds

Every investor’s goals, needs, tolerance, allocation and capital are vastly different. For this reason, you need to look at the variety of bonds with an eye toward the type that is the best fit for you.

• Convertible bonds: a type of hybrid security that allows investors to eventually convert their debt into stock (equity), depending on the circumstances and price
• Zero-coupon bonds: bonds that are sold at a discount and that do not pay interest; U.S. savings bonds are considered zero-coupon
• Callable bonds: a bond where the issuer “calls back” or buys back the asset before it has reached its full maturity date
• Puttable bonds: a bond where the bondholder has the right to “return” the asset before it has reached its full maturity date

Because there isn’t a strict standard for each of these bonds, some will contain more than one variance, which can make it more confusing for beginner investors. If you’re unsure of the specific bond’s variety, you should do your own research or stick to straightforward bonds that are clear and understandable.

Are Bonds Taxed?

As we previously mentioned, there are taxable and tax-exempt bonds as well as bond funds. Some examples of bonds that are subject to state, federal and sometimes local taxes include:

• Corporate bonds
• Global bond funds
• Diversified bond funds

These bonds will have taxes on the interest you make as well as capital gains. U.S. Treasury bonds and any other government debt securities are exempt from state and local income taxes but are taxable at the federal level, so you will still need to report these types of bonds on your federal taxes each year.

Often, investors may look into municipal bond funds because the money you make from them is typically exempt from both federal and state taxes for residents of the issuing state. While the interest income from a municipal bond is tax-exempt, any capital gains are still taxable and need to be reported. Always read the fine print and investigate taxes on debt securities before you begin investing in bonds.

How Are Bonds Priced?

Learning about how to invest in bonds and understanding how they’re priced are two very different aspects of the process. The three primary influences on how a bond is priced are supply and demand, term to maturity and credit quality.

When you buy an individual bond, you can expect to receive regular coupon (interest) payments for most bonds, usually every six months. In comparison to an individual bond, when you buy a bond fund, you can expect a monthly payout of the income earned by the bond fund. You must bear in mind that when you sell or redeem your bond, you may sell at a higher or at a lower price than the price you paid. That difference can be an additional source of earnings, or it may result in a loss. That change in price is one of the main factors that determines a bond’s total return.

However, you can’t just buy a bond and hope for the best. Despite its low volatility, a bond’s price will change in response to increases or decreases in interest rates and inflation.

Inflation, Interest Rates and Bond Pricing

Think of the relation between inflation, interest rates and bond pricing as cyclical. Bonds are subject to interest rate risk, since rising rates will result in fluctuating prices. However, as you may know, interest rates respond to inflation: When prices in an economy rise, the central bank typically raises its target rate to cool down an overheating economy. These new rates are typically determined toward the beginning of the year.

Additionally, inflation tends to erode a bond’s face value, which can be concerning for investors who are holding intermediate-term and long-term bonds. Because of this relationship, bond prices are quite sensitive to changes in inflation, inflation forecasts and rising interest rates.

Therefore, it’s important to always evaluate market sentiment and the state of the economy before investing in bonds. Understanding which market indicators to look for will help you become a confident individual investor, especially when it comes to bonds.

When Is a Favorable Time to Buy Bonds?

So, if you need to watch out for inflation and rising interest rates before investing in bonds, when are bonds a good investment?

As a general rule of thumb, interest rates and bond prices move in opposite directions, which means that as these rates increase, bond values will decrease. For people who rely on fixed income, it’s important to be in tune with market sentiment, as well as overall interest rates, to see if buying bonds makes sense or not.

To answer the question of “When is a good time to buy bonds?,” you will have to account for inflation risk. This term refers to the potential for investment losses that result from a change in inflation. If inflation rises, the value of a bond or other fixed-income investment will decline and vice versa.

To reduce risk even when interest rates are high, investors can choose to hold bonds of different durations and maturity. That’s why it’s important to have a diversified portfolio, so when bond prices decrease, you have other investments to safeguard your assets.

Benefits of Investing in Bonds

Even though bonds may not be a good investment during periods of inflation or increased interest rates, there are numerous benefits of investing in bonds such as:

• Low risk: tend to be lower risk than securities like individual stocks
• Fixed income: provide a predictable income stream, especially for retirees
• Diversification: give investors a certain level of protection during volatility
• Capital preservation: a way for investors to preserve capital
• Interest: have better interest rates than a bank account or certificate of deposit (CD)
• Bankruptcy protection: bondholders are paid before stockholders when a company fails

For retirees, one of the main benefits of investing in bonds is the ability to have a predictable stream of revenue coming in that you can count on. This type of fixed income comes in handy when you don’t have a pension to pay for daily living expenses.

Diversification is also one of the many benefits of investing in bonds. This is because when stocks go down, bonds tend to go up and vice versa; therefore, bonds may help preserve capital in your portfolio and act as a “shock absorber” for your other assets during times of volatility.

Despite the numerous benefits of investing in bonds, there are things you should consider before taking the plunge.

Disadvantages of Bonds

Of course, like any marketable security, there are benefits of investing in bonds and there are disadvantages of bonds. These include:

• Low long-term returns: historically lower long-term returns than individual stocks
• Sensitive to rising rates: bond prices fall when interest rates go up, especially long-term bonds
• Inflation risk: if the rate of inflation outpaces the fixed amount of income a bond provides, the investor could lose some purchasing power
• Credit risk: the possibility that an issuer could default on its debt obligation
• Low liquidity: investors may have difficulties finding a buyer during certain markets

Investors should be aware of the disadvantages of bonds so that they can properly diversify with other securities in times of rising interest rates and inflation.

What Are Bond Funds?

Investors who are looking for a less time-consuming strategy may want to look into bond funds as they can often be more efficient than researching and purchasing individual securities. Bond mutual funds are similar to stock funds, in that they are a managed pool of individual bonds. Bond funds have a stated objective to focus on certain attributes or qualities of bond investments.

Like stocks, you also have the option to invest in bond exchange-traded funds (ETFs). Similar to bond mutual funds, ETFs comprise baskets of bonds that follow a particular investment strategy. When looking at different bond ETFs, you will have to choose if you want an ETF that is passively or actively managed. Lastly, bond ETF fees are typically lower than bond mutual fund fees.

You may be wondering how you get paid in a bond fund. Income payments from the bond funds are made monthly and reflect the mix of all the different bonds in the fund. It’s important to do your research on the bond fund’s fee structure before you choose which one is right for you. Some bond funds may have operating expenses and annual account fees, so be sure you know what to anticipate so you’re not caught off guard.

A benefit of bonds funds is that they allow you to buy or sell your fund shares each day, making them inherently more liquid than individual bonds. Additionally, bond funds allow you to automatically reinvest the dividend income.

How to Buy Bonds: Individual and Funds

As we mentioned above, there are two bond markets: primary and secondary. There are rules for newly issued bonds, which reside in the primary market, and pre-maturity bonds on the secondary market. Newly issued bonds are purchased in the primary bond market, like when you buy an initial public offering (IPO) of a stock. As an investor, you can buy newly issued bonds at their offering price.

Buying U.S. Treasury bonds is relatively straightforward and can be done through a broker or directly through Treasury Direct. Investors can buy newly issued government bonds through auctions several times a year.

However, buying individual corporate bonds can be tricky, especially if you are trying to acquire newly issued corporate bonds. You’ll typically need a relationship with the bank or brokerage that’s managing the primary bond offering.

Buying municipal bonds as new issues requires an investor to participate in an issuer’s retail order period. You’ll need to have a brokerage account directly with the financial institution backing the bond issue, and complete a request that indicates the quantity, coupon and maturity date of the bonds you want to purchase. You can find the available coupons and maturity dates in the bond prospectus, which is given to prospective investors.

On the secondary market, investors can purchase bonds before their maturity date. These purchases are made via brokerages, specialty bond brokers or public exchanges. One important aspect to note is that if you decide to buy on the secondary bond market, prices may be less transparent and will require more research. The secondary market offers more options and varieties of bonds than the primary market but also presents unique challenges for individual investors.

When it comes to purchasing bond funds or ETFs, you buy a piece of a bond portfolio that most likely does not have a maturity date. Just like ETFs composed of stocks, these Bond ETFs trade on an exchange, so you can buy or sell them during the regular stock market hours. Both bond mutual funds and ETFs can be purchased through a brokerage account.

Are Bonds a Good Investment?

If you’re asking yourself, whether bonds are a good investment, the answer will depend on the state of the economy, how diversified your portfolio is and what your individual goals are.

As we mentioned above, bonds are incredibly sensitive to inflation and interest rates, so we would recommend investors do their research before investing in bonds. However, it never hurts to add bonds or bond funds with varying lengths of maturity to diversify your portfolio, especially if you are a long-term investor.

For retirees, bonds and bond funds can often provide a reliable steam of income. In fact, the AAII Allocation Models recommend for a conservative investor to have 60% of their portfolio in fixed income and 40% in stocks. Intermediate- and short-term bonds could be a good addition if you have a conservative allocation.

Lastly, bonds and bond funds can offer investors numerous tax benefits. However, you will need to decide on your own if bonds are a good investment for you. Every investor is different, that’s why we want to give you the tools and resources you need to make informed decisions about your portfolio.

How to Invest in Bonds With AAII’s Resources

As with other securities, the best bond investment strategy depends on your goals and appetite for risk. Consider your investing timeline, portfolio diversification and account structure before investing in bonds. Longer-term bonds usually offer high interest rates due to their riskier nature; investors with a longer timing horizon for goals can consider longer-term bonds that offer those higher rates. Investors who will soon need money, like retirees or those approaching retirement in the next five to 10 years, should opt for shorter-term bonds to decrease risk and receive returns sooner than later.

Although we do not offer bond screening tools, there are numerous educational resources at AAII.com that can help you get started with investing in bonds. Additionally, you can check out our allocation models to learn more about what makes up a healthy, diversified portfolio. If you’re approaching retirement, you may also want to check out our extensive article database filled with tax strategies including bonds.

Become and AAII member today to get exclusive access to unbiased education free of advertising and start adding bonds and bond funds to your portfolio today.