When it comes to investing, many people talk about equity or stocks. Bonds are also a form of investment security with the purpose of being considered for a well-diversified investment portfolio and generating investment returns.
A multitude of reasons exist for allocating some of your money into bonds, but generally, they are known to be less risky assets than stocks. While stock prices can hike or decline rapidly, bonds tend to have less of an upside, but they also inherently contain less downside risk. In essence, bonds stand a better chance of preserving capital, and, in some cases, earning an additional revenue stream.
As you read this guide, you'll learn about the key considerations and terminologies, different types of bonds, the benefits and setbacks that come with investing in bonds, and how to select the bonds that fit your unique situation.
How do bonds work?
Bonds are issued because corporations and governments need money to finance projects.
Investing in bonds all starts with a business or government needing to finance a project which they’re not able to finance themselves. Typically, these projects are large scale, requiring vast amounts of capital. In the case of a government, it may require loans to finance public services or public infrastructure, such as the building of parks or schools. In the case of a corporation, bonds could finance research and product development, fund international expansion, or help with the acquisition of another company.
What are the key considerations?
Who issued the bond? For example, is it a sovereign government, governmental agency, or corporation bond?
What is the likelihood of the issuing entity being able to repay its obligation? In other words, is the underlying entity creditworthy?
Is the interest you earn from your bond taxable?
What is your intended investment horizon?
Can you buy and sell bonds?
There's a market for buying and selling bonds. And the market value of bonds rises and falls in relation to their par value depending on many other factors such as interest rates. As interest rates fall, the value (price) of a bond rises. Going back to our example, since you've bought 5,000 Corporation C bonds for $1,003 each and a 5% coupon, the par value of each bond is $1,000 and the bank's underwriter fee is $3.
So, let's say the interest rates of bonds fall from 5% to 3% for a company similar to Corporation C. Many investors would rather buy your bonds at $1,100 each than pay $1,003 for a 3% coupon bond from Corporation A. When investors buy a bond above its par value, it's called premium to par. In this scenario, investors would buy your Corporation C bonds at a price that is $100 above par value.
Now, since interest rates are inversely proportional to the value of bonds, the reverse is the same. The interest rates of similar bonds rising to 7% will devalue your bond’s market price. The value of your bonds will fall below its par value in what is known as a discount to par.
However, you don't have to worry about the market value of your 5,000 bonds if you don't plan to sell. You may still hold your bonds until they mature.
Is there a risk of bond issuers defaulting on a bond?
Yes. Some entities can default on a bond. Fortunately, there are credit ratings that classify bonds based on the realistic possibility of paying back investors. These ratings are issued by independent credit agencies, such as Moody’s and Standard & Poor’s.
Investment grade or high-quality bonds are generally rated AAAs to BBBs. Once a bond is rated BB or lower, they are considered lower quality, higher risk bonds. The lower-quality bonds are called junk bonds. High-quality bonds usually have lower interest rates when compared to low-quality bonds, to reflect that they are less risky. In other words, the borrower is more likely to be able to repay the loan and coupon payments.
Ratings can be downgraded if the credit quality of the issuer deteriorates, or upgraded if fundamentals improve.
In case the corporation goes bankrupt, the company will be responsible for paying back its creditors or bondholders before they distribute any cash to its stock-holders. If the company doesn’t have enough funds, it’s possible that its bondholders (creditors) will get nothing.
What types of bonds can you invest In?
Government bonds and corporate bonds are the largest sectors of the bond market, so today we’ll discuss only US Treasuries, municipal bonds and corporate bonds.
There are other types of bonds as well, including mortgage-backed securities that specialize in funding certain sectors, such as housing.
These are considered the safest possible bond investments. Because they're so safe, yields are generally the lowest available. Treasuries are extremely liquid. You'll also need to pay federal income tax on interest from these bonds.
In the US, they're also considered general obligation bonds because the loan is backed by the US government's ability to tax its citizens. US Treasuries come in various maturities ranging from treasury bills maturing within 1-year to 30-year maturities.
These bonds are loans issued by country, state, and local governments. They're usually deployed to fund public services such as schools and parks. For general obligation bonds, the issuer is obligated to use any means, usually taxpayers’ funds, to repay the loans and interest rate. For revenue bonds, the interest rate and loan payments are made using income generated from projects such as a hockey arena, and as such considered riskier.
Investors in high tax brackets may consider municipal bonds in their own state, as they are generally not taxable in the state that they were issued. However, always consider your state’s creditworthiness.
Corporate bonds are often defined by how likely the company will be able to repay the loan and associated interest. Investors are recommended to review the corporate bonds prospectus before they make investments. Just bear in mind that a bond prospectus can sound complicated, full of legal jargons.
So what is a corporate bond prospectus?
Some of the information you should expect from a corporate bond prospectus include:
- Credit ratings
- Date of maturity
- Interest rate
- Call provisions (Under what circumstance can the corporation terminate the bonds?)
- Payment timing
- Payment plan
- Risk factors (there are quite a few!)
Investing in foreign bonds, whether treasury or corporate, may also bring additional risks. When the bond is issued in local currencies, you’ll need to take into account an exchange rate fluctuation.
As mentioned previously, the easiest way to diversify into bonds is to either invest into US treasuries or bond funds. Bond funds are suitable for both diversification and for liquidity.
When you buy a share of mutual funds or exchange-traded funds (ETFs), you are essentially buying a basket of bonds. The price of the mutual fund or ETF will fluctuate each day based on factors impacting the underlying bonds, such as credit ratings and interest rate change in the country.
However, be careful if you're considering investing in a bond fund and you should ascertain the level of risk you are willing to take as well as the maturity. For example, if you plan to buy a house in three years and need your funds by then, we recommend that you invest in a bond fund with a maturity of less than three years.
Benefits of investing in bonds
A Sense of purpose or civic duty
Bonds can mean more to an investor than simply making money or preserving your capital. If you bought municipal bonds from your city for the purpose of building a hospital, that can come with a sense of wellbeing because you're contributing to a worthy cause. It’s a good feeling to know you aren't just making money but also helping fellow citizens have a higher quality of life.
Bonds can be used by investors as an instrument for preserving capital. Entities who issue bonds are obliged to pay interest rates throughout the duration of the bond's terms and repay invested capital once the loan matures. And if they really need to, governments always have the option of raising taxes to repay the loans. And in the case of corporations, even in the eventuality that a corporation goes bust, creditors are paid first before shareholders. This in itself is one benefit of investing in bonds over investing in stocks.
Depending on which type of bond you buy, your yield and capital can be protected from taxes. For example, for a local investor, interest rates from municipal bonds are exempt from state and county taxes. On the federal level, returns of treasury bonds are exempt from state taxes.
So, now you know the benefits of investing in bonds, where can you buy bonds?
Where can you buy bonds?
There are multiple ways to buy bonds. You can invest through a mutual fund or ETF, buy from the US Treasury Department, or go with a brokerage firm.
US Treasury Department
In the US, Treasury Direct is perfect for buying treasury bonds because you don't have to deal with transaction fees and varied bond prices. You’ll need to be at least 18 years old, have a US bank account, and hold a form of identification such as a social security number.
These are the brokerage platforms that enable the trading of bonds to investors like you. There are many out there and some of them include TD Ameritrade, E*Trade, Charles Schwab Vanguard and Fidelity. When buying from brokerages, just know that bond values can fluctuate due to transaction fees.
We’ve looked at a few topics concerning bonds in this article guide and here’s a summary:
Bonds are basically loans that investors give to entities such as corporations and governments.
As an investor, generally, you'll generally get the face value of the bond back at maturity, and for coupon-bearing bonds, regular coupon payments until the loan matures.
There are three main types of bonds: treasuries issued by federal governments, municipal bonds from state and local governments, and corporate bonds from businesses.
You can buy bond funds through ETFs and mutual funds, for example, Vanguard and Fidelity. US treasuries can be purchased via many different vehicles including Treasury Direct.
Investment opportunities with Republic
Although Republic does not offer bonds, we hope this helps you better understand how bonds work.
If you’re considering investing in alternative assets and diversifying your portfolio, then check out Republic for investment-worthy venture-backed companies across multiple industries.
We carefully and rigorously sift through these opportunities and accept the most promising investments. Less than 5% of companies make it through our platform. It's at this point that we support and monitor them for success.
We invite you to take a closer look at some of these exciting and promising companies. Who knows? You might just be joining the early stages of the next tech unicorn.
Regardless of your course of action, remember that it’s all about taking that very first step. So start now!
Still don't know where to start?
Simply start saving! Set a budget you can maintain - something that doesn't stray far from your current lifestyle. Save today and invest tomorrow for a stronger financial future.
This educational article is provided by Republic to help its users understand this area of the market, it should not be construed as investment advice as it is impersonal, disinterested and was produced by Republic for Republic’s users, without remuneration received or expected.
How to invest in bonds