Investing in Bonds: An Introduction

First Things First: What is a Bond?

To say “a bond is a form of debt” makes it sound as though bonds are something you’d try to avoid at all costs—after all, nobody wants to be in debt! With bonds, though, you are not the one incurring debt; on the contrary, you are the debt collector. When you invest in bonds, you are loaning out money—to the city, a company, or the government—and collecting interest on it. When the bond matures, the original amount of the loan (called the principle) is returned to you. Sounds pretty good, right?

However, not all bonds are created equal. The difference between them lies in the entity that issues them (a.k.a. who is borrowing the money). When you buy bonds, it’s important to be aware of whom you’re lending money to, since you have to be able to trust them to pay you back! Additionally, the interest on different types of bonds is taxed differently. So, let’s take a look at the different types of bonds and their advantages and drawbacks:

1. Treasury bonds are bonds issued by the U.S. government. When you invest in treasury bonds, you are lending the federal government money to finance its budget deficits. Since these bonds are backed by the “full faith and credit” of the U.S. government, they are touted as virtually risk free. Their interest is also exempt from state income taxes! However, because of their low risk, treasury bonds pay a lower yield (a.k.a. less interest) compared to other types of bonds.
2. Agency bonds are another type of U.S. government bond, but their yields are higher than those of treasury bonds because they are not “full faith and credit,” meaning that they are not backed by an unconditional guarantee. While their risk is still considered to be minimal, the interest you receive on this type of bond is taxable at both state and federal levels. Agency bonds are issued by federal agencies, like the Federal National Mortgage Association and the Government National Mortgage Association (which you may know as Fannie Mae and Ginnie Mae, respectively).
3. Corporate bonds are bonds issued by companies or financing vehicles. There are two different kinds of corporate bonds: Investment-grade corporate bonds and high-yield corporate bonds.
   1. Investment-grade corporate bonds are high-quality bonds that are issued by companies or financing vehicles with relatively strong balance sheets. They are rated at least triple-B (on a scale where triple-A is the highest, then double-A, single-A, triple-B, and so on) by index providers Standard & Poors and/or Moody’s Investors Service. Therefore, the risk that these companies won’t be able to pay you back (called the risk of default) is low. The yields on this type of bond are higher than those of government bonds; however, they are fully taxable.
   2. High-yield corporate bonds are issued by companies or financing vehicles with relatively weak balance sheets and ratings below triple-B. This means that the risk of default is high. These bonds are typically issued by companies that are trying to raise a lot of money fast, so along with their high risk, they also promise high yields. While “high-yield” bonds might sound tempting, they are generally considered to be low quality. It might help to remember that they are also called “junk bonds.”
4. Municipal bonds are bonds issued by a local government (municipality) in order to fund various projects. Also called “munis,” these bonds are not subject to federal taxes—and if you live in the state where the bonds are issued, they might not be subject to state taxes, either. Some municipal bonds carry more risk than others. Some are insured, which means that even if the issuer defaults, you will be reimbursed by their insurance company.
5. Foreign bonds are issued by foreign borrowers in the currency of the country in which they are sold. With foreign currency–denominated bonds, the issuer promises to pay you back (including interest) in another currency. Exchange rates are thus more important than interest rates, when these foreign currency payments end up being converted into dollars.
6. Mortgage-backed securities, or MBSs, are bonds secured by home and other real estate loans. As an investor in an MBS, you are buying a share of someone else’s loan and then collecting interest on it. This type of bond involves “pre-payment risk”—that is, people will often pay their mortgage loans off early, which means that the amount of interest you will ultimately collect is unpredictable.
7. “Alternative lending” is a term used to describe various other types of loans that are similar to bonds and are usually issued by individuals or business owners. As an investor, you can find these borrowers through online marketplaces like Lending Club. The terms of these “peer loans” are usually much shorter than those of other types of bonds (meaning that they mature faster), and the minimum amount required to invest in them is generally a lot smaller.

How Do You Get Access to Bonds?

Now that you’re aware of the different types of bonds that exist, you might have a sense of which type would be best suited to your needs. You might even feel like you are ready to start investing in bonds—but how do you go about doing that? Well, once again, there are several options:

3. You can buy the bond yourself, either from a broker or directly from the U.S. government (if it’s a treasury bond). You can also buy bonds from a brokerage account. “Full service” brokerage accounts (Merrill Lynch, Morgan Stanley, and Wells Fargo Advisors are a few that you may have heard of) work extensively with you to develop an investment plan, in exchange for a high fee. Meanwhile, “discount” brokerage accounts (like Charles Schwab, Vanguard, and Fidelity, to name a few) are more of a do-it-yourself option, offering online information and trading software for a much lower price.
4. You can also get access to bonds indirectly, by pooling your money with other investors in a mutual fund. Mutual funds are managed by professional investors who, in exchange for a fee, choose a group of bonds to invest all the money in, allowing you to reap the benefits of their expertise. This convenience and assurance makes mutual funds an appealing option for first-time investors, or for anyone who prefers a more hands-off approach.
5. Finally, there are CDs and MYGAs, two investment products that are not bonds exactly, but that have distinctly bond-like characteristics: A CD, or Certificate of Deposit account, is a product sold by banks and credit unions. When you put your money into a CD, the bank invests it in bonds and then gives you some of the return in the form of interest. The main advantage of investing in a CD is its security: it’s basically just like a savings account, but with a higher interest rate, and you can’t withdraw any money from it until it matures. Generally, the longer a term you agree to, the higher your interest rate will be. A MYGA, or Multi-Year Guaranteed Annuity, is very similar to a CD, except that it is issued by an insurance company instead of a bank, and it has the additional benefit of tax deferral.

How Do Bond Rates Work?

Okay, so maybe you know, now, how you’re going to get your bond. Now you want to gain a better understanding of how bond rates work, so that you can be sure that you’re getting a good deal.

First of all, a bond’s rate is synonymous with its yield, or its yield-to-maturity (YTM). The YTM is the average annual return you can expect to receive from a bond after holding it to maturity, or the end of its agreed upon term.

Now, as you may have already started to figure out, a bond’s YTM depends on how risky the bond is: the higher the risk, the higher the yield. This makes sense, because borrowers with less established reputations (like companies) need to promise a higher interest rate in order to compete with lower-risk borrowers (like the U.S. government) and attract investors.

Pros and Cons

Just as each particular type of bond has its advantages and drawbacks, bonds in general have their pros and cons when compared to other investment options.

Unlike stocks, where you never know how much money you are going to make, one advantage of investing in bonds is that you always know how much money is owed to you, ahead of time. Perhaps for this reason, however, bond returns tend to be much lower than stock market returns (remember: the higher the risk, the higher the yield). For these same risk profile reasons, bonds tend to be more attractive and make up a greater percentage of investors’ portfolios as investors grow older and look towards shorter investment horizons. Moreover, the income generated by bonds can be a healthy complement to a retiree’s Social Security benefit. 

While bonds are lower risk than stocks, in many ways, it’s still important to remember that no bond is ever truly risk-free. Even the U.S. government could conceivably default on a loan some day, even though that hasn’t happened since the days of Alexander Hamilton.

Ultimately, conventional wisdom is that bonds should be a part of every investor’s portfolio, particularly as investors get closer to retirement. The type of bonds you choose, and how you access them, is up to you—just make sure that you do your research on your borrowers beforehand, by looking at their ratings to determine whether or not they’re worth the risk.