When the stock market starts feeling volatile, many investors flock to bonds, which are seen as less risky but still provide income investments.
How do you buy bonds and what are the risks? We’ll discuss that and more below.
Table of Contents:
What are Bonds?
Bonds are basically debt obligations. Rather than buying a share of ownership in a company–as you do with stocks–you loan money to a company or government entity. You receive interest payments regularly, and then, when the bond’s term comes to an end, you get the face value of the bond.
You make money from bonds by buying them and holding them until maturity, or by buying them and then trying to sell them for a higher price than you paid. For bonds, prices and yields move inversely to each other. That is, if the yield is higher on the bond, the price is lower.
How to Buy Bonds
Stocks are fairly easy to buy and sell because they are listed on public exchanges. But bonds don’t have a centralized trading system. Instead, if you want to buy municipal or corporate bonds, you buy them from brokers. Check with your own broker to see if they offer bonds. Some brokers that allow you to buy bonds include:
Ally Invest – A trading platform geared towards newer investors. With Ally Invest, you can buy and sell bonds, stocks, currencies, ETFs, futures, and mutual funds. There’s a $1 fee for bond purchases.
TD Ameritrade – One of the largest investment brokerages in the U.S., it acts primarily as an online trading platform for self-directed investors. With TD Ameritrade, you can buy and sell bonds, stocks, ETFs, options, mutual funds, and futures. The fee for bonds is calculated on a net yield basis.
E*TRADE – Another trading platform that is great for beginners. With E*TRADE, you can buy and sell bonds, stocks, mutual funds, ETFs, options, and futures. The fee for bonds is $1.
You Invest by J.P. Morgan
You Invest – An online investment platform from J.P. Morgan that offers both a self-directed and managed investment plans. You can trade fixed investments (bonds), stocks, ETFs, options, and mutual funds. There’s no fee to buy U.S. Treasury bonds, new corporate bonds, municipal bonds, or government agency bonds but there is a $10 fee per trade on bonds on the secondary market.
You can also use networks like Paladin to find brokers that can help you buy bonds. Paladin works by vetting financial professionals and then helps match you with an advisor, based on your financial goals. Paladin is free is easy to use. Try it here or read the full Paladin Review.
When you buy bonds through a broker, you might have to pay a transaction cost or commission. In many cases, the cost you pay is higher than what you’d pay to trade stocks.
Using Mutual Funds and ETFs to Buy Bonds
You can also access bond investing through mutual funds and exchange-traded funds (ETFs). These investments represent a collection of bonds that share characteristics.
For example, a bond mutual fund might include different Treasury bonds and highly-rated corporate bonds that are designed to help you maintain a regular income. By having a mix of different maturities, the bond mutual fund can help you achieve your desired results, and the fund manager would purchase new bonds to replace those that reached maturity.
Likewise, there are also bond ETFs. While you don’t own the bond directly, ETFs allow you to gain exposure to bonds by trading a single investment. Plus, ETFs are traded like stocks on the exchange, making them more accessible and less expensive in some cases. Many robo advisors use ETFs to create portfolios based on the principles of asset allocation.
So, whether you decide to use a robo advisor or go through a broker to buy bonds individually–or even get bonds directly from the U.S. government–there are a number of ways you can add bond investments to your portfolio. Carefully consider how bonds might fit into your portfolio in a way that helps you reach your short-term and long-term financial goals.
Learn More: Stocks vs. Bonds: Find The Perfect Mix
Using Bonds in Your Portfolio
Because it’s considered less risky to invest in bonds, many people use them to protect their portfolio against market volatility. If the stock market falls, having bonds can provide a measure of stability and provide income by paying out interest.
Most financial professionals use Modern Portfolio Theory to help you determine how much of your portfolio should be in bonds. With this approach, the portion of your portfolio divided between different assets matters more than the individual investments. With MPT and asset allocation, you’re much more likely to use bond mutual funds and bond ETFs to reach your goals.
One common rule to determine how much of your portfolio should be in bonds is to take your age and subtract it from 100. That gives you the percentage of how much should be in stocks (although many professionals now say to use 120). The remainder should be in bonds. For example, if you’re 30 years old, 100 – 30 = 70. So, 70% of your portfolio should be devoted to stocks, while the remaining 30% should be devoted to bonds.
However, with longevity, and other factors, you might want more growth for longer. If that’s the case, you could use 120 as your base. So, 120 – 30= 90. You’d put 90% of your portfolio in stocks, and the other 10% in bonds. (Using 120 as your number only works if you’re at least 20 years old.)
In any case, the idea is that the closer you are to needing to use your money, the more of your portfolio should be in bonds. As you approach retirement or some other financial goal, shifting more of your portfolio into bonds can potentially provide you a shield from market volatility while providing you with relatively stable income.
Another strategy when deciding how to invest in bonds is to consider bond laddering. This is similar to CD laddering, but you might potentially receive higher yields when you use bonds. With bond laddering, you set up a system where your bonds mature at different points, and then you can use the proceeds to purchase more bonds.
For example, if you have $40,000 and you want to build a bond ladder, you might purchase $10,000 in bonds at 5, 10, 20 and 30 year maturities. Depending on how the situation goes, you might be able to purchase bonds with higher yields down the road after your bonds reach maturity. Others purchase bonds with maturities closer together in order to turn the bonds over more frequently. However, you might end up paying higher fees because of the frequency.
Risks of Investing in Bonds
As with any investment, there is always the risk of loss. While bonds are generally considered “safer” than stocks (and that’s why the returns are usually lower than with stocks), there is still the potential for loss.
In some cases, the issuing organization might default on its debt. If that’s the case, you might not get all of your principal back — not to mention the future interest payments that you’d miss out on.
Another risk is that if you get bonds that have low yields, you might not be able to keep pace with inflation. If all you want is protection for your buying power, you can use Treasury Inflation Protected Securities (TIPS) to help reduce some of this risk.
Finally, if you decide to buy and sell bonds on the secondary market, you run the risk of selling for less than you bought a bond for. Additionally, you might see some losses due to fees related to trading.
U.S. Treasury Bonds
This article has dealt with company and government bonds, but there’s a special kind of bond I haven’t discussed yet: U.S. Treasury Bonds.
These are a little different. You don’t have to go through a broker to purchase them. Instead, you can get them by going to TreasuryDirect.gov and see what’s available. When you buy Treasury bonds direct, you save on some of the fees.
U.S. Treasury bonds are some of the most popular bonds in the world. They are easy to buy and sell, but because they are low-risk (they have the backing of the U.S. government), they typically have low yields.
How to Invest in Bonds — FAQs
Bonds can be a good investment, so long as you understand the associated risks. If you are following the Modern Portfolio Theory, you’ll have a mixture of stocks and bonds in your portfolio. And remember, while bonds aren’t a sure thing, they are used to mitigate some of the volatility associated with the stock market. As you near retirement, your portfolio will likely include a higher percentage of bonds.
Related: Worthy Bonds offers you an opportunity to earn 5% on your money, with an investment of as little as $10. It’s a peer-to-peer investment site, where you can invest money in bonds issued by small businesses. The bonds aren’t guaranteed by a government agency, like FDIC, but many of them are collateralized by business inventory.