Bonds are debt securities that can be used as a savings and investment vehicle for clients. It is generally very important for individual investors to have a well diversified portfolio, and with bonds, investors will be able to invest in various types of companies or government debts. Bonds are also known as fixed-income securities which are designed to provide steady interest payments (coupon) and principal repayment on maturity. The main benefit of fixed income securities is the fact that they provide a steady stream of income and are relatively safer than other investments such as stocks. The price at which you can buy or sell a bond depends on the current interest rates of similar bonds in the market. From the forgoing, it can be deduced that having a diversified portfolio as well as staying abreast of happenings in the bond market are key to having a profitable investment basket.
A bond is a debt obligation of an entity that lives for a designated number of years and pays periodic interest payments to bondholders before maturing, at which point the face value (or par value) can be repaid. Fintalent’s bonds consultants define it as an investment vehicle designed to generate a steady stream of income and/or cash in the future. Bonds can be used by companies, municipalities or government agencies to fund a project, buy equipment or pay for some other expense. The company, city or government agency issues the bond to raise the money it needs. The funders of these bonds—who invest money up front that will later be repaid with interest payments—are the buyers of these bonds.
Bonds may also be issued by individuals and companies that don’t need capital, but instead want to invest their money in something safe and secure (like a bank CD) while collecting interest payments throughout the duration of the bond.
Bonds represent a type of fixed-income investment, which are intended to be held for a specific amount of time. The value of a bond is determined by its interest rate and the credit rating that the issuer has been given by investors.
Types of Bonds
There are three main types of bonds (each with varying levels of risk and reward):
Government Bonds: These bonds are held by institutional investors like banks and government agencies, who earn interest payments as well as return principal when they mature. There are also short-term issues that can be bought on the open market or in a mutual fund. U.S. Government Bonds have earned an average annual return over the last 10 years of 6%. Read more on Vanguard.
Corporate Bonds: These are bonds issued by corporations and municipalities to raise capital for a specific project, such as building a new factory. Corporate Bonds earn significantly higher interest rates than Government Bonds but also carry greater risk of default—where the bond’s issuer fails to pay interest or return principal. Over the last 10 years, Corporate Bonds have earned an average annual return of 8% in the US alone.
Municipal Bonds: Municipal Bonds are issued by states and local governments like cities, counties and school districts. They’re generally considered lower-risk bonds than Corporate Bonds, because there is usually less chance of default by the bond issuer. However, they do have a higher interest rate than Government Bonds and sometimes have restrictions on who can buy them. Municipal Bonds have earned an average annual return of 4.3% over the last 10 years in the US. Learn more about making money from municipal bonds .
Why should I invest in bonds?
Bonds are an extremely liquid investment—you can buy and sell them almost instantly in the market. Bond funds and bond trading platforms allow you to invest in hundreds of different bonds from many different issuers. You can select from among a wide variety of fixed-income securities that vary widely in their risk, maturity date and price per share (i.e., their value).
Investing in bonds can help you grow your principal while earning a yield, or interest payment, that’s much higher than what you would get from a bank CD. Bonds are also known as fixed-income investments because they pay off a set amount on the investment’s maturity date—generally ranging from six months to 30 years—regardless of recent trends in the market.
Bonds are less volatile than stocks, so they may be a more effective way to protect your portfolio against downturns in the market. Bond prices generally rise when interest rates fall (as investors look for higher yields) and vice versa.
There are two main types of bonds: Government and corporate. Within each group, there’s a wide range of maturity dates, maturities and interest rates (see chart below). The longer the maturity date, the more your bond is likely to decrease in value when interest rates rise.
The credit rating of the bond is an important consideration for investors. An issuer’s credit rating determines what the bond requires of its owners (you) in terms of tax-filing status; most bonds require that you file as a “non-individual”—that is, you’re considered a pass-through entity for tax purposes, like a partnership or limited liability company (LLC).
High-quality bonds include those with a BBB or AAA rating (“investor-friendly”) or an AA, A, B or C rating (“speculator-friendly”). However, many bonds issued by companies in junk bond status—with BBB or lower ratings—have very high yields but are considered speculative investments based on their low credit ratings.
As you can see from the above chart, there are usually more Government Bonds than Corporate Bonds. With Corporate Bonds, the longer the maturity date and current interest rate, the higher the yield. Whereas with Government Bonds you can buy both short-term and long-term issues with slightly different rates.
How do bonds compare to other investments?
Bonds are considered a “fixed income” investment, which means that the interest you earn on the bond is fixed. But unlike cash, which doesn’t grow and earns no interest, bonds can actually appreciate in value much more than cash as interest rates change. If a bond’s price increases after you’ve purchased it, you will receive capital gains distributions along with your periodic interest payments. Plus there are ways to hedge yourself against fluctuations in the bond market through things like index funds or even covered call options .
When compared to stocks, bonds are relatively low-risk and predictable in terms of their overall long-term performance. Because bonds’ interest rates are fixed and withholding tax is generally withheld at the source, investors do not have to worry about paying taxes on their income from gains. However, if a bond’s owner doesn’t hold onto it until the maturity date, they may pay taxes on their interest payments as well as capital gains.
Bonds are generally used in combination with stocks to diversify your portfolio. For example, if you’re investing in the stock market, be sure to diversify your risk by investing in a bond mutual fund or ETF alongside it. Or if you’re a pension plan or retirement account beneficiary, you may be able to invest up to 20% of your account value in bonds for tax-deferred and tax-exempt income.
How do I buy bonds?
If you want to buy a bond directly from an issuer—for example, from the U.S. Treasury—there are two main ways: If you have an Individual Retirement Account (IRA), there is no cost associated with buying bonds within this account type. However, you must wait until you reach age 59½ to withdraw these funds without paying a penalty. Other types of IRAs don’t allow direct bond purchases. If you want to purchase bonds within a brokerage account, there are two main ways: Buy a bond from a bond mutual fund , in which bonds can be bought and sold at any time during the day. (The overall market value of the entire portfolio is calculated once at the end of the trading session.)
Be sure to understand the specific costs and risks of buying bonds, including interest rates , due dates , and potential capital gains taxes on bonds that are held until maturity.
Bonds can also be sold (pushed out). If you sell bonds prematurely, you’ll pay capital gains taxes on any increase in their price since you bought them, even if they weren’t redeemed before their maturity date. If you hold a bond to maturity, these gains are tax-free.
Remember that while bonds are generally safer than stocks, they’re still subject to large price fluctuations—particularly as interest rates climb. Be sure to consider the following when evaluating your bond options : How much risk can you stomach? What’s the expected total return over time (this may differ from the current yield)? Which bonds best fit in your overall investment strategy? How do I buy bonds? While bonds are generally safer than stocks, they’re still subject to large price fluctuations—particularly as interest rates climb. Be sure to consider the following when evaluating your bond options :
How are bonds taxed?
Bond interest is usually taxable—but it can be tax-deferred until the bond matures. After that, you’ll likely have to pay taxes on both your income and gains if you sell at a profit. While interest rates are rising, bonds that are bought at a premium and sold within one year will incur short-term capital gains taxes. But most other investors who hold bonds longer than one year don’t pay capital gains taxes on their investment—and in some cases, they may qualify for long-term capital gains rates (see table below).
If a bond is held in a retirement account, such as an IRA or 401(k), you don’t have to pay taxes on the income it generates. When bonds are owned by an institution, such as a pension fund, they’re often not taxable until redemption. However, if they’re redeemed before maturity, they may be subject to capital gains tax.
If you’re married and your spouse is in a lower tax bracket than you, the bond income may be taxed at that lower rate.
How can I build a diversified portfolio of bonds?
Bonds are often used to broaden the allocation of your portfolio by adding a fixed income component. And while bonds can be purchased in any amount and at any time, there are ways to reduce your risk when investing in them. (For more information on this topic, see How do I get started with mutual funds.) For example: If you borrow money to purchase a bond (covered call option), you won’t suffer the losses that can come if the bond price drops before its maturity date.
My investments are held in my IRA. Is that a problem?
No, any investments you have in your IRA will not be taxed for at least five years. So you can buy bonds without penalty during this time. (However, if you’re making withdrawals from your IRA during the five-year window, a penalty of 5% will be applied.) The five-year period begins once the particular year is complete—so if you purchase a bond in 2016, it’s eligible for the five-year period starting on January 1, 2017.
My investments are held in my non-deductible IRA. Is that a problem?
You may be able to deduct the interest you pay on your mortgage or home improvement loan—but not the interest you pay on any bonds. You’ll need to consider the after-tax cost of buying a bond compared with other types of investments. If bonds are part of your overall investment strategy, here are some options: Mortgage: If you’re planning to remodel your home or buy a new home, and will have a higher tax bracket over the next five years, it may make sense for you to borrow for these purposes before converting your non-deductible IRA.
How can I diversify my bond investments?
Bonds are generally considered less risky than stocks—and they also tend to have lower correlation with other investments. Bonds tend to have a low correlation with other investments, and their own risk doesn’t change much over time. You can hedge this risk by purchasing or choosing a bond fund that holds a mix of bonds from different sectors and countries. For example: Government bonds as a part of an international bond fund, are less volatile than U.S. Treasury issues.