When you begin investing, one asset category you will come across are bonds. Yet, there are also quite a few types of bonds that you’ll have access to and must understand before investing in any.
If you are building the popular three fund portfolio, bonds will play a role in the diversification of your investment portfolio.
However, that portfolio style makes investing easy and there is not much work involved on your end.
But, to be a good investor you should always understand the basics of why you are investing and what you are investing in.
Therefore, no matter your investing style or strategy, it’s still important to grasp the basics of the common bond categories.
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What is a Bond?
Bonds are simply loans that people make to corporations or specific governments. Bonds are issued as a way for governments or companies to raise money and then pay the money back over longer periods of time with interest. They are usually low risk and secure, which makes them an attractive way for investors to diversify their portfolios.
Bonds tend to act inversely to stocks too. This means that by investing in bonds, investors can have a more balanced portfolio that is less impacted by a stock market crash or recession.
Now, this doesn’t mean bond prices will never go down, but it can be a good addition to help minimize losses a bit during market volatility.
Stocks Vs. Bonds
Hopefully, you have the basic understanding of what a bond is from the definition above. But I’ll break it down a bit further, by including the difference between stocks and bonds.
Stocks: These are shares of a company you can invest in and own, whether through individual shares like Apple, or through an index fund that tracks specific companies and diversifies your stock investments more. I prefer Vanguard index funds, which help lower the risk but still get broader exposure to companies in the market. More risk, but more potential reward with stocks or index funds.
Bonds: And bonds are considered to be safer investments, because they have less market volatility than stocks would have and generally, you have a guaranteed fixed interest rate. While bond share prices on the stock market can go down, the volatility is less aggressive. The other difference here is there is usually less upside compared to when stocks rise, lower risk and lower reward.
What Are The Common Types of Bonds?
Just like there are different types of companies and stocks, there are also various types of bonds too. And each category of bond has a particular set of regulations and how they work.
Naturally, there are tons of bonds out there that you can choose to invest in. Plus, there are a huge selection of bond ETFs and Index Funds too. It can be a bit overwhelming!
However, for the average investor you probably do not need to know about every single bond type. Instead, the below common types of bonds should be sufficient enough.
The first common and often most important type of bond is Treasury Bonds, that are issued by the US Treasury Department.
Since they come from the government, Treasury bills are considered one of the safest investments. Meaning the risk is minimal because it reflects based on how the U.S. economy is running.
Treasury bonds don’t offer the highest return and are considered more of a safeguard than to help your portfolio grow. They are usually sold in denominations of $1,000, however, they can be bought for smaller amounts through bids or through an online broker.
And this type of bond also comes with different “maturity” periods — the time it will take for the government to pay back the loan on your investment.
Depending on the type of bill you buy, the maturity could be ranging from 2 years, 5 years or even 30 years. Once the maturity date is reached, the government pays back your initial loan (the principal) in full. Another benefit to buying Treasury bills is you won’t pay state income taxes on interest.
Another popular type of bond are Corporate bonds, which is debt issued by corporations rather than the government. Now, these companies can raise money via debt for construction or large company projects — instead of raising money through equity or stock.
The company issues bonds and then repays a specific amount of interest to the investor until the bond maturity date is over. And these can range from short-term, mid-term, and long-term in loan types.
What’s more enticing here for investors is that the returns tend to be higher than Treasury bonds for example. However, there is also more risk since these are not government-backed loans.
And within this corporate bond option, you have additional variations to consider within it too. You can purchase junk bonds, certificates of deposit (CDs), and others.
Municipal bonds are debt issued by U.S. state and local governments who are raising money to fund a specific project, such as parks, road construction, or a bridge.
And municipal bonds are also secure and allow investors to invest without having to pay state, federal or income taxes. These types of bonds are slightly more risky than Treasury bonds as yes, a city can go into default costing you the investment. But are still lower risk compared to stocks.
Municipal bonds also traditionally offer lower interest rates than US Treasury bonds, however, in 2008 municipal bonds did offer higher returns for a brief period of time.
Additionally, there are types of Municipal bonds too which include general obligation bond and revenue bonds.
Why You Might Want to Invest in Bonds
Bonds are an asset class worth adding to your portfolio to help balance out your investments and to weather against stock market corrections or other volatile time periods.
But here are a few reasons why you may want to consider investing in bonds or mixing some into your current portfolio:
Safer: as mentioned above, buying debt from the US government or municipalities is considered much safer than stocks from companies. Although bonds will always carry some kind of risk too, they are less risky than stocks and are therefore a good way to diversify a portfolio.
Fixed income: when you buy a bond, you will be receiving a specific interest rate every month for that bond until you reach the maturity date. For those who are retired or who like the idea of fixed income, this is a potential benefit and puts you at less risk.
Tax breaks: if you invest in US Treasury bonds or municipal bonds you won’t need to pay any state taxes on the interest you gain.
Although you’ll get a higher return on your investments with stocks, bonds are a good way to spread risk across your portfolio.
Those who are more risk-averse or are closer to retirement will want to allocate a larger proportion of their portfolio to bonds.
And those who want to maximize their portfolio return or are in their early twenties may want to have a higher proportion of their portfolio in stocks and less in bonds.
How to Buy Bonds
Now that you know about the types of bonds and more about them, you might be wondering how you can buy them. Well, you have two specific options to consider: directly from issuer or through a online broker.
Directly From Issuer
There are several ways to buy bonds. The method that works best for you mainly depends on the type of bond you are buying and what fees you are willing to pay.
If you are buying US Treasury bills, you can buy Treasury bonds easily online through Treasury Direct. You’ll need to set up an account, be over 18, have a Social Security Number and an address in the US. You won’t be charged any fees and you’ll be able to pick and choose the type of bond that fits your preferences.
Municipal and corporate bonds are usually bought through an online broker. Buying them directly requires committing to large amounts of money and having the correct broker expertise.
Directly From Broker
You can easily buy individual bonds through an online broker. These include corporate, municipal and U.S. Treasury Bonds. You’ll be able to choose the bond you want to invest in, how much you want to commit and easily keep track of your bonds’ performance. Just make sure you pick a broker that offers low fees and is reliable!
If individual bonds are not what you’re looking for, you also have the option to buy bond ETFs. These are like a basket of bonds that include several different companies from a specific sector (such as automotive).
ETF funds are usually passively managed and will offer access to both short-term and long-term bonds. With bond ETFs, your portfolio will be even more diversified and you won’t need to worry about picking individual bonds.
Bond Index Funds
Bond index funds are another type of fund that is passively managed. Instead of acting as a basket of bonds from a specific industry, a bond index fund tracks and matches a specific index.
For example, you could choose to buy an index fund that includes over 8,000 bonds and tracks the US bond market with 30% in corporate bonds and 70% in US Treasury bills: Vanguard Total Bond Market Index Fund.
Bond index funds are highly diversified and fees are incredibly low since index funds do not require active management. For those who don’t want to be hands-on in their bond investing, bond index funds offer a great alternative.
What Kind of Bonds Should I Buy?
The type of bond that you should buy depends on your risk tolerance, how much of your portfolio you want to allocate to bonds and what kind of return you’re looking for.
If you’re looking for an investment that is safe and reliable and you’re not too worried about the return, Treasury bonds and municipal bonds may be your best bet. If you want something that is a little less secure but may offer higher returns, corporate bonds may suit you best.
Or If you want something that is already diversified, cheaper and managed for you, bond ETFs or bond index funds are the way to go. This is currently how I invest in bonds, but it’s my personal choice based on my investment horizon.
If you want to diversify your bond portfolio, you can also choose to purchase several bond types, all with different maturities and interest rates.