How to buy bonds

How to buy bonds. It’s not as difficult as it might seem to purchase bonds. But before you buy, you must understand the various varieties and know what to look for in a bond.

One option to invest is through bonds, which involve lending money to a government or firm rather than purchasing stock (like stocks).

Due to their reduced volatility and relative safety compared to stocks, bonds are often recommended by financial advisers as a piece of your portfolio. Bond funds, such as mutual funds or exchange-traded funds (ETFs), are an easy method to gain exposure. Investors can purchase these products from most major brokerages.

Buying bonds: where to begin

Due to the larger initial investment needed to start investing, purchasing bonds may prove to be slightly more difficult than purchasing stocks. Although most bonds have a $1,000 face value, there are alternatives to purchase bonds for less. There are a few places you may purchase them:

A broker

Learn how to set up a brokerage account to purchase bonds from an online broker. By using this strategy, you’ll be purchasing bonds from other investors who want to sell them. In an initial bond offering, purchasing a bond directly from the underwriting investment bank may also entitle you to a discount off the bond’s face value.

An ETF

An ETF normally purchases bonds from a wide range of issuers, however some funds concentrate on short-, medium-, and long-term bonds or offer exposure to particular markets or industries. Because you don’t have to buy in big chunks and a fund offers rapid diversification, it’s a wonderful choice for individual investors.

The term of a bond is the amount of time until the bond matures. The fact that longer-term bonds often offer higher interest rates due to their increased interest rate risk is a significant distinction between short- and long-term bonds. In other words, long-term bonds are more likely to be exposed to and sensitive to fluctuations in interest rates over a longer time frame.

Directly from the U.S. government

Investors can purchase government bonds directly from the federal government on the Treasury Direct website without having to pay a commission to a broker or other middleman.

What to watch for when you buy bonds

When investing in bonds, there are two ways to generate income. An option is to purchase the bond, hold it until it matures, and then cash it in for the principal and interest.

But another option is to sell the bond early and profit if the price has increased since you bought it. If the borrower’s credit rating rises or interest rates drop, the price of a bond may increase. Interest rates and bond prices are inversely correlated, which means that when interest rates rise, bond prices fall and vice versa.

Bond investments are not all created equal. To determine whether certain bonds fit your portfolio, follow this three-step process:

1. Can the borrower pay its bonds?

The answer to this issue is crucial since the average investor won’t even think about purchasing bonds from a firm that can’t fulfill its promise to repay money lent with interest. You can determine if the business will be able to pay its debts if you do some investigating.

Rating agencies assign ratings to bonds, with Moody’s, Standard & Poor’s, and Fitch being the three major ones that dominate the market. They assign credit ratings to businesses, governments, and the bonds they issue in order to determine creditworthiness. According to school grades, the higher the rating, starting at AAA, the more likely it is that the company will fulfill its obligations and the lower the interest rates it will have to pay.

Corporate bonds. Beyond ratings, examining the interest rate a firm pays in relation to its income is the fastest approach to assess the safety of a company-issued bond. Due to their comparatively higher default risk, corporate bonds often have higher interest rates than government bonds. The business will eventually run into problems if it doesn’t have enough income to cover its obligations, just like a homeowner paying off a mortgage each month.

Start by looking at a company’s income statement, which will show its most recent yearly operating income and interest expense. Every publicly traded U.S. corporation has this information available in a 10-K filing, on its website, or in the EDGAR database on the website of the U.S. Securities and Exchange Commission. Operating income is a better indicator of a company’s capacity to pay its debts than net income since it subtracts taxes and interest payments (which are tax deductible).

Government bonds. Because governments often don’t have significant surplus earnings that suggest stability, evaluating government-issued bonds can be challenging. the positive news In general, investing in government bonds is safer; federal government bonds issued by the United States are the world’s safest and are rated AAA.

The interest rate on U.S. government bonds, also known as Treasury Bonds or T-bonds, is referred to by investors as the “risk-free rate” since they are thought to be so safe. As a result of the minimal default risk, government bonds often do not offer higher interest rates. Treasury Inflation-Protected Securities (TIPS) and I bonds are two outliers, whose interest rates are routinely modified based on inflation. As of November 8, 2022 [1], I bonds are offering unprecedented yields of about 7%.

Municipal debt Although historically safe, bonds issued by cities, states, and municipalities are not quite as impenetrably secure. On the Electronic Municipal Market Access (EMMA) website, which offers a bond’s official prospectus, an issuer’s audited financial statements, and ongoing financial disclosures, such as payment delinquencies and defaults, you can learn more about these bonds.

A government’s credit rating is a decent initial indicator of its creditworthiness; you may then check to see if there have been any defaults recently or other financial problems that could lead to one in the future. Another advantage is that, if you buy municipal bonds in the state where you live, your income from them is often tax-free on both the federal and, in certain cases, the state levels.

Zero-coupon bonds, commonly referred to as “deep discount” bonds, are bonds that bear no interest. They are sold for less than their face value, and if the bond is held until maturity, a profit is generated. A zero-coupon bond is an example of a Treasury bill, or T bill.

2. Is now the right time to buy bonds?

The debt market is where bonds trade after their interest rate has been decided upon and made accessible to investors. The price of the bond will then fluctuate depending on changes in market interest rates.

Bond prices typically move in an anticyclical manner. Interest rates increase when the economy grows, which lowers bond prices. Bond prices rise as interest rates decrease as the economy slows. Bonds may seem like a terrific investment during boom times (when prices are at their lowest) and a sell when the economy begins to improve. But it’s not quite that easy.

Investors attempt to forecast whether interest rates will rise or fall. However, delaying the purchase of bonds could amount to trying to time the market, which is not regarded as a wise move.

Many bond investors “ladder” their bond exposure to deal with this uncertainty. Bonds with different maturities are purchased by investors. The ladder rises as the bonds age because the principal is reinvested. Laddering successfully spreads out interest rate risk, albeit it could result in a lesser yield.

3. Which bonds are right for my portfolio?

Your risk tolerance, tax status, time horizon, and whether or not you will ever need the income from these bonds will all play a role in what kind of bonds are best for you.

Corporate, government, and municipal bonds may all be included in a solid bond allocation in order to diversify the portfolio and lower principal risk. In order to lower interest rate risk, investors can also stagger the maturities.

Because bonds are often sold in $1,000 increments, diversifying a bond portfolio can be challenging because it can cost a lot of money to develop a diverse portfolio.

Purchasing bond ETFs is much simpler in contrast. These funds can give you diversified exposure to the bond kinds you prefer, and even if you can’t invest a lot of money at once, you can mix and match several bond ETFs. By spreading out your exposure, you may also enjoy the benefit of lowering your risk exposure by not putting all of your eggs in one basket.