Bonds are generally considered an essential component of a well-rounded investment portfolio. They offer income and diversification benefits, while typically carrying less risk than stocks. With the right approach, you can get as much or more yield that you would typically get from certificates of deposit or savings accounts.
Here’s a look at the role for bonds in your investment portfolio, and an overview of how to buy them.
How bonds work : An overview
Bonds are debt obligations—basically IOUs—that are issued by companies, governments, and government agencies and repaid over time. When you purchase a bond you are becoming a lender. In exchange for your loan, you get interest that is paid out at a predetermined rate. This rate is referred to as the bond’s yield. Then, when the bond matures, you receive back the full amount of your purchase payment.
Bonds work very differently than stocks, which provide investors with a share of a company’s profits. Stock prices are heavily influenced by the likelihood that a company’s profits will rise or fall, while bond prices are driven largely by supply and demand, interest rate movements, and the likelihood that a given bond will be repaid.
The role for bonds in your portfolio
Bonds offer benefits than make them a valuable counterpart to stocks in most investment portfolios. While stocks tend to offer higher returns, bonds offer other advantages:
- Steady income: Bonds tend to offer relatively predictable returns, including regular interest payments.
- Good hedge: Bonds perform differently as investments than stocks, which helps to reduce long-term volatility.
- Lower risk: Bonds generally offer a higher degree of security than stocks, though some bonds are riskier than others.
Types of bonds
Most bonds purchased by ordinary investors fall into two categories: Bonds issued by governments and bonds issued by corporations.
Government bonds issued by the U.S. federal government, for instance, are referred to as Treasuries and are considered a relatively low-risk debt investment. The yield on Treasuries tends to be relatively low as well. Bonds issued by foreign national governments may be considered less safe, but they offer the potential for higher yields.
Municipal bonds, usually referred to as “munis,” are a type of government bond issued by state or local governments. The main advantage of munis is that the returns they generate are exempt from federal taxes and, in some cases, from state and local taxes.
Corporate bonds are debt issued by large companies. They come with a wide range of interest rates (depending on the risk they represent) and maturities. These bonds are usually divided into two categories:
- Investment grade bonds are issued by companies that have earned a credit rating of at least triple-B from credit rating agencies.
- High-yield bonds are issued by companies with lower credit ratings, which means they present a higher risk in exchange for a higher yield than their investment grade counterparts.
How to get started buying bonds
It’s possible to buy bonds directly from the issuer. While that makes sense in some situations—for example, the U.S. Treasury department’s website is one of the simplest places to buy Treasuries—ordinary investors more frequently buy and sell bonds using one of the following methods:
- Buying individual bonds through a brokerage account: You can buy bonds through most brokers just like you would stocks. Fees vary greatly, though, and navigating all the options can be confusing.
- Buying bond mutual funds and ETFs: You don’t need to make decisions about specific bonds to purchase when you buy a bond mutual fund or exchange-traded fund (ETF). Instead, the fund or ETF company chooses them for you. These investment vehicles also offer the benefit of diversification through exposure to a mix of bonds.