The ABC of Investing in Bonds
Simply put, bonds are a form of debt. Consider them loans or IOUs, and you’re the one who’s serving as the bank.
“You loan your money to a company, a city, the government — and they promise to pay you back in full, with regular interest payments,” The Wall Street Journal writes. By lending money to an organization for a specified amount of time, you can expect that organization to repay you the amount you initially paid when the bond reaches the end of its term. You’ll also receive interest payments, which are based on a set interest rate.
Many personal financial advisers recommend maintaining a diversified investment portfolio, according to Investing in Bonds. That means mixing it up between bonds, stocks, and cash.
The plus side of bonds is that you get back your entire payment once a bond matures, making it a safer investment than the stock market. According to Brass, bonds feed you a steady stream of interest payments throughout the term, which can help balance riskier investments (again, stocks).
You’ve also got options. You can choose from various term lengths that range from three months to thirty years. And you’ve got a say in bond sources. Corporate bonds are issued by corporations; municipal bonds are issued by government entities, such as states and cities; and U.S. Treasury bonds are issued by the U.S. Department of the Treasury.
What to consider
Assess risk: Before investing, take a look at all of the key variables that come with investing in a bond. Look at its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status.
Price: “The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to par (100 percent of the face, or principal, value),” writes Investing in Bonds. But bonds traded in the secondary market can fluctuate in price and respond to a variety of factors such as changing interest rates, credit quality, general economic conditions, and supply and demand.
Interest Rate: There are three different types of interest rates that bonds can pay — they can be fixed, floating, or payable at maturity. Fixed rates carry the interest rate that is established when the bonds are issued with semiannual payments. A floating rate bond has a rate that is reset periodically in line with interest rates on Treasury bills, along with other benchmark interest-rate indexes, according to Investing in Bonds. Payable at maturity means you won’t receive periodic interest payments. Instead, you’ll receive one payment at maturity that is equal to the purchase price plus the total interest earned, compounded at the original interest rate.
Maturity: You’ll have three options here.
- Short-term: maturities of up to five years
- Medium-term: maturities of five to twelve years
- Long-term: maturities greater than twelve years
Short-term bonds are typically considered stable and the safer option, while long-term bonds can provide greater overall returns.
Determining your bond score
“The Standard and Poor’s (S&P) rating system is used to assess the credit quality of a bond, meaning the likeliness that a bond issuer will pay you back,” Brass writes.
Here’s a look at the investment grades:
- AAA: This is the best score a bond can have.
- AA: It’s not as great as AAA, but it’s still pretty good.
- A: This is still fairly good, but it’s certainly a bond you’ll want to watch closely.
- BBB: It’s OK, but there’s a chance that it could be an unreliable choice in the long run.
Here’s what to know about speculative grades:
- BB: This means that as of right now, the bond can pay off the debt. But whether it can in the long run is up in the air.
- B: There’s a decent chance this bond could default.It gets riskier from this point on.
- CCC: You’re looking at a 50-50 chance of seeing a return.
- CC: It’s now more likely the bond won’t be able to pay its debt.
- C: This grade means it will more than likely default.
- D: There is no point in investing in this bond — it’s basically worthless.
Bonds typically have a lower investment rate. There’s a chance that a bond’s interest rate could be so low that it might not beat the investment rate, Brass says. Make sure you’re aware of this and looking out for it before purchasing a bond. If you’re looking at an investment that won’t make more than inflation, you’re not going to earn any additional money — you’ll just get back the money you originally put in.