No, we're not talking about everyone’s favorite British spy. We're talking about bonds that are used as investments, people! Still, bonds do seem to be a bit of a mystery to some folks.
A bond promises a predictable return over time, and they’re often backed by governments. Because they’re seen as a “safe” investment, they attract a lot of investors. In fact, more than $105 trillion dollars are invested in the global bond market!1 But what exactly is a bond? And are they a good place to park your hard-earned money?
Let’s see if they belong in your retirement portfolio.
What Is a Bond?
Bonds are a type of fixed income investment (though bonds with variable interest rates are gaining in popularity). That just means they’re designed to give you a steady stream of income. In this case, that’s in the form of dividends and interest payments. So when you buy bonds, you’re the lender, not the borrower!
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Usually when a government or a company turns to bonds, it’s because they need more money than a bank can lend. By issuing bonds, they’re basically handing out IOUs where they agree to pay you interest on the loan and return your money at a specific date in the future. That’s right, you’re loaning them your money!
How Bonds Work
At their most basic level, how bonds work is a straightforward process. They’re like the certificates of deposit (CDs) of the investing world: easy to set up, relatively low-risk, but quite often, low-reward.
In return for your loan to a government or company, you get consistent interest payments from the borrower until the bond reaches its maturity date—that’s the date they’ve agreed to pay you back for the original loan amount. If you decide to jump into the bond market, here’s what to expect.
Let’s say you buy a $1,000 bond from your local government. The term of the bond is 20 years with a fixed annual interest rate of 5%. In this scenario, you’d receive an average of about $85 in interest each year (nothing to write home about!) from the city throughout the bond’s term, and then you’d get your initial $1,000 back at the end of the 20 years when it matures. That means after two decades, your initial $1,000 investment turned into $2,700. But look, people, getting a 5% return per year is not good growth when you compare it to the stock market averages.
Types of Bonds
There are all types of bonds out there, but the three main types you’ll come across are corporate, municipal and U.S. Treasuries. Let’s take a look at each one!
Corporate bonds are offered by private and public companies to fund their growth by financing ongoing operations, new projects or acquisitions. Say a large athletic-wear company wants to acquire an overseas manufacturer, but it will cost $10 billion. To fund their acquisition, the company issues bonds, borrowing the money from bondholders with the intent to pay them back the full amount plus interest.
Like private and public companies, state or local governments issue municipal bonds (or muni bonds for short) to fund public projects like building bridges, roads or new schools. One way municipal bonds are different than corporate bonds is that municipal bonds can have some tax benefits. Depending on where the bonds are issued, you may not have to pay state or local taxes on them. You might also be able to avoid paying federal taxes on the interest you earn.
U.S. Treasury Bonds
Again, each bond is like an IOU, only in this case you’re the lender, not the borrower. U.S. Treasury bonds give the federal government cash to pay for government spending not covered by taxation. Backed by the “full faith and credit” of the U.S. government, these are often promoted as one of the safest investments you can make. Because, as we all know, the government is known for handling money well. (No comment.)
Investing in Bonds
You can invest in bonds by buying new issues (initial bond offerings), purchasing bonds on the secondary market (where previously issued bonds are bought and sold), or obtaining bond mutual funds or bond exchange-traded funds (ETFs). The price you’ll pay depends on what you’re willing to bid and what the issuer is asking. There are three main ways to buy and sell bonds:
1. Use a broker. The first way to jump into the bond market is to use a broker. They’ll help you buy and sell bonds with other investors in the market.
2. Buy and sell directly with the U.S. government. It has a program that lets you avoid paying a fee to a broker or other middlemen.2
3. Look for bond mutual funds and bond exchange-traded funds (ETFs). You can easily review the details of a mutual fund or an ETF’s investment strategy and find ones that fit your investment goals.
You can sell your bonds before the maturity date, but this comes with risks that we’ll cover in the next section. Understanding how to buy and sell bonds can be tricky for new investors. So, don’t try this at home.
Bond Ratings and Risks
So, how are you supposed to know which bonds are good to invest in and which aren’t? Well, bonds are given ratings, or scores, based on how risky they are. Basically, this rating is tied to the issuer’s ability to pay you back.
Bonds that are believed to have a lower risk of default are given higher ratings. And the higher rated bonds tend to be issued at lower interest rates. Lower rated bonds need to provide incentive to the buyer, so their rates are higher. Anyone investing in bonds should make sure they know the rating of the issuer. And never invest in low-rated bonds (aka junk bonds)—unless you can afford to set fire to your money!
While we’re on the topic of risks, here are a few of the most common ones to look out for in the bond market.
This means the issuer may default on its bonds. When that happens, you don’t get your money back, and you can forget about the interest.
Interest Rate Risk
If you’re planning to sell your bond before the maturity date, there’s the possibility that a change in overall interest rates could reduce the value of the bond. As interest rates rise, bond prices fall, and vice versa. So you might have to sell it at a discount from what you paid, which means you’d lose some of your initial investment.
If interest rates are low and inflation increases, inflation could outpace the return and sink your purchasing power.
This is the risk that you can’t sell bonds when you want, meaning you can’t get your money out when you want either.
The possibility that a bond issuer “calls,” or retires, a bond before its maturity date. This is something an issuer might do if interest rates decline (kind of like if you wanted to refinance your mortgage to snag a lower rate). This forces the investor to reinvest the money at a lower interest rate.
The longer a bond’s time to maturity, or duration, the higher exposure it has to changes in interest rates. This is just a measure of how a bond’s price might change as market interest rates go up and down. If you buy a bond with a 10-year maturity, you’ll ride the ups and downs for a longer period than if you bought a bond with a 1-year maturity. Basically, when interest rates go up, the value of your bond falls.3
So, Are Bonds a Good Investment?
We don’t recommend betting your retirement on bonds. You’re better off investing your money in a mix of growth stock mutual funds.
What a lot of people find attractive about investing in bonds is the prospect of steady payments over the life of the bond. Having that stable income makes it easy to plan out your spending, which is why bonds are tempting additions to many retirement portfolios.
Others like to point out that bonds could take some of the sting out of Tax Day—especially municipal bonds, which are usually tax-free at the federal, state and local levels. While subject to federal taxes, Treasury bonds are also free from state and local taxes.
Bonds have a reputation for being “lower-risk” investments because they don’t fluctuate as wildly as stocks. But here’s the thing: The returns you get from bonds just aren’t impressive, especially when compared to mutual funds, because they barely outpace inflation. Remember, you want to beat the market so you can build wealth.
Get With a SmartVestor Pro
Complicated topics like bonds should motivate you to get an investment professional in your corner— someone who can help me separate the facts from the fiction. No matter where you are in your investment journey, it’s always a good idea to sit down with someone, like a SmartVestor Pro, who can help you set goals for your financial future.