How to Invest in Bonds: A Beginner’s Guide

Daniel Penzing
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Investing in bonds doesn't have to be complicated. In fact, it's a great way to keep your portfolio diverse.

If you've ever wondered how to invest in bonds but have been overwhelmed by all of the information out there, this is the guide for you! Investing in bonds is very different than stocks. With stocks, you can (usually) either lose all of your money or make a huge amount of money in a very short amount of time. With bonds, however, you're typically either going to earn a small amount of interest or your bond may default (in essence, you'll lose all of your money). That means that when you invest in bonds, it's important to make sure that you keep your risk low.

This guide will teach you how to invest in bonds. We'll take an in-depth look at bond funds, types of bonds, and how to automate your investments in just a few simple steps. This will walk you through the basics … all the way up to advanced ideas that you can explore once you understand everything.

Want to start investing in bonds? Download this free guide.

Types of Bonds

Before you invest, you have to know what kind of bond you want to invest in. There are plenty of different types of bonds, but we'll break it down into a simple chart for you.

In this Guide:

What are Bonds?

Bonds are considered to be easier than stocks to understand. Generally, bonds are fixed-income investments that can be issued by both companies and governments. Bonds are normally acquired through government institutions or financial institutions that lend money to companies.

Bonds are sold at a nominal price, and the owner usually earns interest which is periodically deducted from the initial price of the bond. In case the loan period ends with the borrower not paying back the initial loan or interest, the company that issued the loan can take action by seizing assets.

The current interest rates are set according to the risk the borrower poses. Governments have a lower risk for paying back the loan than an individual, and thus bonds issued to governments often have a low interest rate. On the other hand, companies risk of not being able to pay off the loan usually results in a high interest rate. The higher the risk of losing money, the higher the interest rate.

In this post of ours, we are going to look at ways in which you can invest in bonds and help you earn a good return on your investment.

Where Can You Invest in Bonds?

Bonds can be bought and sold (bought at one price and sold at a higher price) on most exchanges. Bonds can also be traded among individuals and with financial institutions, either through the internet or a broker.

Bonds are issued by governments, companies, and even banks or groups of people (such as a syndicate). Governments, companies, and banks often issue bonds as a way to raise money to cover other expenses, to expand a business, or otherwise to increase its income.

Remember, bonds do not pay out interest until the bond matures, or reaches its own end date. However, there are bonds that pay out interest (coupon payments) and bonds that do not. Some bonds make coupon payments until they reach their maturity date, while others make coupon payments until the date of their maturity. In the United States, the Securities and Exchange Commission (SEC) requires that all bonds pay out a minimum amount of interest.

If you’re nervous about investing in a bond that doesn’t pay a coupon, consider investing in a bond index fund instead. Bond index funds mimic the performance of an index without paying out coupon payments. As a result, bond index funds are low maintenance and can be a great place to start with fixed income investing.

As with stocks, bonds can be classified in a variety of ways.

ETFs and Mutual Funds Bonds

Bonds are basically a loan given to a company or the government. When you invest in bonds, you are lending money to the borrower and will hopefully be paid back.

Bonds pay a fixed interest rate. You will often see a portion of a bond referred to as the “coupon,” with the coupon rate being the interest rate that the bond will pay the investor.

You can invest in bonds in a number of ways. Here are three of the most popular:

  • Bonds through a brokerage, such as Scottrade or E*Trade
  • Bonds through a bank
  • Bonds through a mutual fund or exchange-traded fund (ETF)

Bonds are backed by the value of the debt, so you are highly unlikely to lose money. However, if the issuer (person or company) calls the bond due, demanding payment before the maturity date, the bond will be less valuable to you. The only way that you can lose money on a bond is if the company or government defaults.

Capped and Uncapped Bonds

Bonds can also be capped or uncapped.

Investing in U.S. Government Bonds

{1}. Government Bond Rates
{2}. 1 Treasury Bonds
{3}. 2 Treasury Notes, and Treasury Bills
{4}. Borrowing
{5}. 1 Treasury Bond Yield
{6}. 2 USA Debt
{7}. What You Should Know before Investing in Bonds
{8}. The Secrets to Buying, Selling, and Owning Bonds
{9}. FAQs about Bonds
{10}. 1. What should I know about trading bonds as an individual investor?
{11}. 2. Are there any online websites devoted to government bond investing?
{12}. 3. The Do’s: What are the red flags to avoid when you buy bonds on your own?
{13}. 4. What about bond mutual funds and ETFs? Should I buy those as a novice?
{14}. 5. What’s the difference between a risk-free bond and a non-risk-free bond?
{15}. 6. What’s the difference between buying U.S. Treasury Bonds and buying corporate bonds?

Investing in Corporate Bonds

It is a far more profitable and safer investment when compared to stock trading since you are not concerned about the fluctuation of the price of the commodity or the market. Bonds are a great way to earn steady interest payments and offer a higher level of liquidity.

Here are some simple tips that you should keep in mind while investing in corporate bonds:

Look for the name of the bonds issuer which will be on the face of the bond. Try to invest in the name of the company that you have some level of familiarity with. This will ensure that you are aware of any events that might affect the company or its operations.

Check the date on which you can register your ownership for the bonds. Normally, there is an expiry date mentioned at the bottom of the bond.

Be aware of the coupon rate that the company is paying you. The coupon rate is the rate of interest that the company will pay you on an annual basis till the date specified on the bond.

The term of the bond is the amount of time, in years, that it will take the company to pay you the amount of the original principal.

These are some simple tips that you should follow while investing in corporate bonds. If you are still not sure of what you should be looking for, take a look at the infographic below provided by Loyal 3 Brokerage.

Investing in Municipal Bonds

Investing in municipal bonds is generally an effective way to reduce your taxable income when you purchase the bonds. This usually means that your income is reduced by the interest rate of the bonds; however, you also need to consider penalties that may be associated with the bonds and deductibility of tax payments in the future.

If you purchase individual municipal bonds, you may have to pay income tax on the amount of interest you earn each year, depending on whether or not you live in the state that issued the bonds. For example, if you live in Missouri and purchase a bond issued by the State of Missouri, you will not need to pay state income tax on the interest you earn. If you live in a different state and purchase a Missouri bond, you will have to pay state income tax on the interest you earn.

You should also consider purchasing bonds through a tax-exempt account. This gives you tax advantages because you do not have to pay taxes on the interest you earn from your bond investment. This is a desirable feature of tax-exempt accounts because you will avoid having to pay federal income taxes on your interest, which you will have to pay on any income earned in a standard savings account.

Your state may offer tax advantages to residents for purchasing bonds of their state. If it does, it will be listed for you on your state’s website.

Why Should You Invest in Bonds?

If you want to invest in bonds, and there are quite a few good reasons why you would want to, you should make sure that you know what you’re getting into. While they are a great option for many investors, their average annual return of 5.9% is significantly lower than stocks (nearly twice as high), and they aren’t for everybody. Read on to find out if bonds are a good fit for you.

If you want to invest in bonds, you should keep a few things in mind. Bonds are a form of credit, so if you purchase a corporate bond, you are essentially lending money to a corporation. You will be rewarded with a guaranteed rate of interest for the life of the bond, and they can be a great way to potentially increase your returns, but if the corporation goes bankrupt or isn’t able to afford to pay back your loan, then you could lose all of your original investment.

Treasury bonds are owned by the US government, and are issued by the Department of Treasury. They have the highest level of safety, but their rates of interest are far below corporate bonds.

Securities are bonds issued by a single organization. These are more risky than corporate and government bonds, but you’re also likely to get a higher rate of interest.

Keep Your Portfolio Diverse with Bonds

When you’re looking to build a portfolio, one of the best things you can do is keep your eye on the prize. If you want to make the most of your investing and ensure your money continues to grow in value, it’s important to diversify. After all, if a recession hits and certain stocks within your portfolio take a big dive, you won’t be wiped out.

Bonds, or more specifically bond funds, can help you do just that. Make no mistake, if the bond market suddenly becomes unstable, there could be a significant impact on the bond market, resulting in sharp losses for investors, similar to what happened during the 2008 financial crisis.

But the more successful your bond diversification plan, the less impact you will feel on your portfolio’s overall value. It may sound a little confusing, but you should try to match the maturity of your bond holdings to the time frame when you’re expecting to need the funds – typically when you’re looking to invest in the stock market.