What are bonds, and why should I care?

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Key Takeaways

  • Owning bonds can diversify your investment risk and generate income.
  • Government bonds offer lower risk and lower yields; corporate bonds — the opposite.
  • Bond fund ETFs can be a cheap way to start investing in this asset class.

If you’re already on the path to financial freedom, having created a budget and starting to save, your next move may be to consider investing toward a specific goal, such as a comfortable retirement.

Figuring out where and how to invest your funds can be overwhelming, but the two most common vehicles are stocks and bonds (our overview of the stock market is here).

The basics

A bond is a financial debt instrument issued by various entities like federal, state and municipal governments – even corporations – to raise money, and often for specific projects. In exchange for buying a certain amount of debt, the holder of the bond receives a promise (or obligation) to be repaid the initial dollar amount at a later time (the “maturity date”) as well as periodic interest payments (also known as the bond “coupon”).

Bond buying is often called fixed-income investing, since the terms of the obligation and what you’ll earn won’t fluctuate after purchase. This is different from investing in stocks where prices can and do fluctuate.

The potential risk when investing in bonds is inflation and interest rates.

If inflation is higher than your bond yield it could eat away at your bond’s return. For example, if inflation rises to 5% and your bond yield is 4% then you’d effectively be losing 1% on your bond investment.

Similarly, if interest rates rise your bond yield could be lower than newer bonds being sold on the market. For example, if you purchased a bond at a 4% coupon rate and interest rates rise, subsequent bonds could be sold at a 6% coupon rate.

But because of the fixed term of bonds they offer investors a chance to diversify their holdings from stocks so that they can generate a regular, consistent, and predictable income stream, as well as a lump sum payout later on.

Here’s a look at the most commonly-held bonds to help you evaluate what might be right for you.

US Treasury Bill

This bond, commonly called a T-bill, is a short-term debt issued by the federal government with a maturity of less than one year. It’s sold in denominations of $1,000 (the maximum purchase is $5 million). While the T-bill isn’t technically risk-free, it’s backed by the “full faith and credit” of the US government, which makes it one of the safest investments you can buy. Because of the low risk of default, the return, or yield, on federal government bonds is low relative to other types of debt. A 6-month T-bill, for example, currently has a yield of about 0.5 percent.

Unlike other federal bonds that offer an interest payment (coupon), T-bills are bought at a discounted price, with the full bond price payable to the holder at maturity. In general, income from federal bonds is exempt from state and local taxes, but is subject to federal income tax.

US Treasury note

This is the intermediate-term federal bond, offering maturities from one to 10 years and also sold in denominations of $1,000. Treasury notes give you an interest payment every six months, and the longer the maturity, the higher your interest payment. The 5-year note yield, for example, is about 1.2 percent, while the 10-year note yield is 1.7 percent. The 10-year is also considered a proxy for the broader economy’s interest rate. When people talk about bond rates moving up or down, they are usually referring to what the 10-year note is doing.

Like all federal bonds, the Treasury note is a lower-risk holding, however, since it’s a longer-term investment, it can leave you more exposed to changes in inflation and interest rates, affecting your overall yield.

US Treasury bond

These federal bonds offer maturities of more than 10 years. The most “mature” bond is a 30-year, often called the “long bond,” which currently offers a yield of about 2.4 percent. Like the Treasury note, Treasury bonds offer coupon payments every six months that pay you for owning the debt. It can be purchased in denominations of $1,000.

The long bond offers a similarly low default risk, but its longer maturity makes it more vulnerable to fluctuating interest rates and inflation compared to shorter-maturity bonds.

Municipal bond

One step up the risk ladder from federal government bonds are the debt instruments issued by cities, hospitals, schools or utilities commonly called “munis” for short. The risk is just slightly higher because, while cities rarely go bankrupt (and thus default on paying back these bonds), it’s more likely to happen than the federal government going bankrupt.

In addition, some municipal bonds called “revenue bonds” carry an additional risk because payback is dependent on some subsequent revenue from a service or facility. Revenue bonds are often issued to help build sports stadiums or convention centers.

The chief advantage of municipal bonds is that they are usually exempt from federal tax. In fact, some local governments issue bonds that also exempt residents from local taxes. For that reason, yields on munis are often lower than that of taxable bonds. On the other hand, there are exceptions to the exception – municipal bonds that are subject to federal tax do exist, which means it’s key for investors to know the exact terms of their bond before purchase.

Corporate bond

Businesses also need to raise funds at certain times – for capital improvements, expansions, or acquisitions – and issuing bonds allows a company to avoid issuing stock and thus diluting the ownership pool. A company also can issue as much debt as it think it can sell, with the understanding that the company’s goal is to eventually pay it all back. That’s something to think about when buying these bonds – because the risk of a company going bankrupt and defaulting on their bond obligations is higher than that of a government, the yields are often higher.

If you’re thinking about buying corporate bonds, a company’s credit-quality is a key consideration. The higher the credit quality, the lower interest rate an investor will get because it’s a safer investment. Credit quality is determined by three primary rating agencies – Standard & Poor’s, Moody’s and Fitch – which analyze a company’s financial health and ability to both make interest payments and return the principal to the bondholder. The agencies will change a company’s rating depending on the company’s standing. In general, “investment grade” bonds are thought to be lower risk and pay out a lower interest rate than non-investment grade, or “high yield” bonds.

Bond ETFs

Like stocks, all kinds of bonds are used to build bond-focused mutual funds and exchange-traded funds (ETFs) that can offer easier liquidity for investors, cheaper entry point (no $1,000 minimums), and also the ability to diversify your bond investments since you can easily purchase multiple ETFs. Bond ETFs are likely to be grouped by type, for example, a municipal bond fund or a Treasury note ETF. Many investors often seek to hold more than one class of bond in order to diversify their investments.

Overall, the most important thing to consider when investing in bonds (or any security) is your risk tolerance. The best way to make investment decisions is to work with a certified financial planner who can help evaluate how much risk you can handle based on your goals and stage in life, as well as the best way to diversify your portfolio based on your existing investments.

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