Types of Bonds to Invest in for Income Investors
Bonds can be a great way to get a steady source of income and lower the volatility of your portfolio. There are five main types of bonds to invest in, each with a different level of risk and return. Let’s take a closer look…
What Is a Bond?
A bond is a loan to a company or government that pays investors back over time.
Borrowers issue bonds when they want to raise capital from investors who are willing to lend them money. The investors usually receive interest payments, or coupons, in exchange for the loan.
The coupon rate is often set at a fixed interest rate. It’s a percentage of the bond’s value. The borrower usually pays this annually or semiannually until the bond matures, or becomes due. When the bond matures, the par value of the loan is returned to the investor, ending the loan.
Par value is the amount that a bond is worth at the time of the bond’s maturity. Many bonds have a par value of $1,000.
But once bonds are trading in the open market, they can trade for above or below the par value.
Someone may buy a bond for $1,050 in the open market, while another person buys the bond for $950 later. Regardless, at the time of maturity, each person will receive $1,000.
Bonds are usually classified in three ways.
- Short term: The bond matures in three years or less.
- Medium term: The bond matures in three years to 10 years.
- Long term: The bond matures in more than 10 years.
Bonds can be a great way to diversify your portfolio because they can offset some of the volatility you get with owning stocks.
The main difference between stocks and bonds is debt versus equity. When you invest in bonds, you’re investing in the debt of a company or government. With stocks, you’re buying equity of a company. You become a partial owner of the business.
Investing in debt is generally safer than investing in equity because of its fixed-return nature. Should a corporation be liquidated, bondholders are paid ahead of shareholders. You can learn more about the benefits of bond investing here.
If you can hold a bond to maturity, it can provide a predictable income stream. If you buy a bond, you can collect steady interest payments while you wait for the bond to mature.
Now that we’ve discussed what a bond is, let’s look at how you can buy a bond…
How to Invest in a Bond?
Buying bonds can be as easy as investing in the stock market. Most large brokers give you easy access. For example, Fidelity and Robinhood let investors buy individual bonds online.
And if you’re looking to diversify your portfolio even more, you might find it easier to invest in a mutual fund or exchange-traded fund (ETF) that focuses on bonds.
You can buy government bonds such as Treasurys directly through a government website. To buy Treasury bonds, you can use the Treasury Direct website without the need for a broker or middleman. You can also buy these bonds through a bank or broker.
Not all bonds are equal. Our own income expect, Marc Lichtenfeld, can take you through things to watch for when buying bonds. In the video below, he will walk you through…
- The mechanics of a bond and how it differs from a stock
- The amount you can expect back from a bond
- Maturity date, the agreed due date of a bond, when bondholders are paid back their principal
- Par value, the $1,000 standard used to price bonds
- CUSIP, a bond’s “ticker symbol,” which is made up of nine letters and numbers
- Coupon, the interest that a bond pays per year in interest based on its $1,000 par value
- Yield to maturity, the return a bondholder will receive if they hold the bond until its fixed end date. Here’s a free bond yield calculator to learn more.
Marc will also show you a step-by-step tutorial of how you can buy a bond. But all bonds are different, and not all bonds can be bought the same way.
To learn even more about key bond market terms, check out how the bond market works. Let’s look at different types of bonds…
Types of Bonds to Invest in
There are five main types of bonds to invest in. Each type of bond has different levels of risk versus return to consider. Let’s take a closer look…
Treasury bonds are issued by the federal government. They pay a fixed rate of interest biannually until they reach maturity. Treasury bonds are issued in 20- or 30-year terms.
Treasury bonds carry the least risk because they’re guaranteed by the federal government. These bonds are virtually risk-free securities issued by the government. As a result, they generally offer lower yields compared with the other bonds listed.
The Treasury Department also issues savings bonds. Retail investors can buy these loans from the U.S. government.
When you buy savings bonds, you’re lending money to the government. There are two kinds of savings bonds…
- A Series EE bond has a fixed rate and earns interest. If the bond is kept for 20 years, it is guaranteed to double in value.
- A Series I bond has a rate that combines a fixed rate and an inflation-adjusted rate. This rate is calculated biannually and aims to protect an investor from inflation.
Government-sponsored enterprises issue agency bonds. These are known as quasi-governmental agencies, like Fannie Mae and Freddie Mac. They aren’t as safe as Treasury bonds.
But these issues are considered safer than the safest corporate bonds. This is because agency bond issuers are guaranteed by the federal government.
States, cities and local governments issue municipal bonds. These bonds are tax-free at the federal level but offer lower interest rates than corporate bonds.
Municipal bonds are high-quality securities with low risk. But these bonds carry more risk than bonds backed by the federal government.
Companies issue corporate bonds. A company can issue a bond to raise capital without diluting ownership with additional shares. A company may also issue bonds to grow the business, begin projects and research, or hire employees.
You can buy corporate bonds on the market through a brokerage firm, bank, bond trader or broker. Most corporate bonds trade on the over-the-counter market.
These types of bonds carry more risk than government-backed bonds. Companies sometimes go bankrupt and aren’t able to pay back their lenders. It’s important to do your research before investing.
Bond investing is a great way to collect income and diversify your portfolio. There are many types of bonds to invest in. But you should always do your research before investing.
To learn more about bonds and other investing opportunities, sign up for Wealthy Retirement. It’s a free e-letter that’s packed with insight from Marc Lichtenfeld.
About Aimee Bohn
Aimee Bohn graduated from the College of Business and Economics at Towson University. Her background in marketing research helps her uncover valuable trends. Over the past year, her primary focus has been researching IPOs and other trends.