Bond Investment Guide
About the Bond Guide
In this guide, we cover the basics of bond investing: what bonds are; why investors would choose to invest in Federal bonds, U.S. Treasury notes, bills, , municipal bonds, and corporate bonds; and how bond rates are determined. While this guide provides an overview and general advice, we encourage you to seek the advice of a qualified advisor in order to receive specific information about your individual financial situation.
What is a Bond?
Simply put, a bond is a debt obligation. Bonds can be issued by the United States government, a state or local government, and by corporations. When you purchase a bond, you are loaning the issuer money. In exchange for being able to use your money, the issuer agrees to pay back the principal in a matter of days, months, or years, and also agrees to pay interest on the loan. Interest can be fixed, floating, or paid upon maturity. Bonds that pay interest regularly typically pay every six months. The rate can be either fixed or variable. Bonds that pay a fixed rate are vulnerable to increases in interest rates. When interest rates rise, the value of an existing bond drops, because it pays less than the increased rate. When interest rates fall, the bond becomes more valuable because newly issued bonds pay less than previously issued ones.
Why Invest in Bonds?
Bonds and equities often move in opposite directions. When stocks are rising, investors want to own them because the returns are higher. But when stocks fall, investors want the safety of the fixed return of bonds. Bonds also pay interest, which is often a source of income for those who have retired. And, unlike stocks, some bonds offer a higher likelihood of having 100% of principal returned.
To see anwsers to 34 of the most common bond investment questions, visit the Bond FAQ.
The United States Treasury issues bills, notes, and bonds. A Treasury Bill has a maturity date of less than one year. A Treasury Note matures in two to 10 years. A Treasury Bond has the longest time to maturity, which is between 10 and 30 years. Treasuries are the safest investments in the world and as such, often pay the least amount of interest. Treasuries should be used for income and capital preservation, not for increasing wealth. They offer a safe harbor for any investor, but younger investors should seek the potentially higher returns paid by municipal and corporate bonds.
Investors flock to U.S. Treasuries during times of political and economic turbulence. The "flight to safety" occurs because Treasuries are backed by the full faith and credit of the United States government. The risk of default is almost non-existent. The federal government can pay interest on the loans and return principal because it has the power to print money and collect taxes.
For more details, visit the US Treasuries page.
States and local governments issue bonds primarily to fund capital improvement projects. The interest earned on "muni" bonds is exempt from federal income tax and very often from state and local taxes, too. Investors in high tax brackets or who live in highly taxed states often benefit greatly from triple tax-free muni bonds. Before investing in municipal bonds, however, you must compare the yield earned on a tax-exempt bond to the yield earned on a corresponding taxable investment. For example, if you're married, file a joint tax return with your spouse, and are in the 35% tax bracket, a 6% tax-exempt yield is the equivalent of a 9.23% taxable yield. In other words, if the tax-exempt investment returns 6%, you should choose it over a taxable investment that returns less than 9.23%. But if the taxable investment earns more than 9.23%, then choose it over the tax-exempt investment.
Municipal bonds are often considered to be a "win-win" for the issuer and the investor. Muni bonds fund capital improvement projects that employ members of the community and add valuable resources or services. One of the best features of muni bonds is their federal tax-exempt status. In many cases, income from the bonds is also free from state and local taxes, which makes them a much sought after investment.
But municipal bonds don't come without risks. States and municipalities have the ability to collect taxes in order to pay the interest and principal due. But states that run into financial trouble are not often willing or able to raise taxes in order to cover bond payments. An increase in taxes affects the way people in the state purchase goods and services, which affects demand, which affects employment, which affects the amount of tax that can be collected.
States and municipalities are reviewed by credit rating agencies and are assigned grades. Investors looking for tax-exempt income need to be sure that they're purchasing high-quality bonds that pay a better rate of return than an equivalent taxable investment.
For more details, visit the Municipal Bonds page.
Corporate bonds are the most exciting – and potentially risky – of the three bond categories. Corporations issue bonds to finance new buildings, raw materials, and even short-term accounts payable. But "buyer beware" when it comes to purchasing corporate notes and bonds. Most corporate bonds are issued as debentures and are not secured by any form collateral. This means that the only guarantee the company is offering is its ability to generate cash flow. While many corporations meet their debt obligations as scheduled, some do not. And even though bondholders are first in line to be repaid when a company declares bankruptcy, they may see pennies on the dollar. Regardless of the company issuing the bond, it's wise to remember that principal is always at risk. Credit ratings play a critical role in understanding how safe a corporate bond is. Companies with credit ratings of AAA through BBB are investment-grade bonds. These ratings represent the highest credit quality and lowest risk of default. Companies with A and BBB ratings are of medium credit quality and present a greater risk of default. BB, B, CCC, CC and C are low quality, non-investment grade bonds. These are also known as junk bonds. A bond with a D rating is already in default.
Warnings aside, corporate bonds also have a tremendous upside with the potential to make investors a lot of money. Balancing risk and reward with diversification and asset allocation is the holy grail of investing. Corporate bonds can be a safe and effective way to earn income for long periods of time. Corporate bonds can also increase in value as they mature, making them even more valuable in the secondary market.
While it seems improbable, investment-grade corporate bonds are an even larger market than U. S. Treasuries. Individuals, corporations, insurance companies, pensions, and mutual funds all hold corporate bonds. They may hold them in conjunction with Treasuries, cash, and high-yield bonds in order to boost returns.
Companies that do not qualify to issue investment-grade instead issue high-yield bonds. As the name implies, high-yield bonds return substantially more than investment-grade bonds because the risk of default is so much greater. But if you're a young investor willing to take a few risks in order to gain larger returns, owning high-yield corporate bonds may make sense. Never, however, risk more principal than you can afford to lose.
For more details, visit the Corporate Bonds page.
Earnings on bonds are expressed in terms of yield. It's important to understand the difference between a bond's interest rate and its yield as they relate to the par value, which is the face value of the bond. An investor who purchases a $10,000 bond for $10,000 has purchased it at par. The interest rate is the amount the issuer is willing to pay to borrow the money and yield is the amount earned.
There are two kinds of bond yields. The first is current yield. It's the annual return on the amount that was used to purchase the bond. For example, if you purchased a bond at par for $10,000 and the interest rate is 5%, the current yield is 5%. If, however, the bond were purchased for $9,000, the current yield would be 5.56%. The second type is called yield to maturity and it is generally a more meaningful measure of return. It's what an investor earns if the bond is held until its maturity date. Yield to maturity takes into account all accrued interest and capital gains if the bond is purchased below par.
For more details, visit the Bond Rates page.
As with any investment, each type of bond has risks and rewards that may be suitable for one investor but not another. While conventional wisdom says that younger investors should stay away from bonds and invest in growth stocks, a good corporate bond fund can also provide a good rate of growth. Bonds are often considered more suitable for older investors, but they run the risk of not keeping pace with inflation if they don't invest in assets other than U.S. Treasuries. Mixing in a bond fund of AAA rated corporate bonds should provide at least a little boost.
While we've covered the basics of bond investing here, there is much more to maximizing the success of your bond investing strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Bond Guidance
- US Treasuries — Details about how to invest in US treasuires.
- Municipal Bonds — Details about how to invest in municipal bonds.
- Corporate Bonds — Details about how to invest in corporate bonds.
- Bond Rates — Factors affecting bond rates, and how to find the best ones.
- Bond FAQ — Frequently asked questions about bond investing.