Even if you’re new to bonds, you probably already know three things about them:
- They are low risk
- They are not as interesting as stocks
- Old people love them
All three are 100% correct. But once you understand how they work and what their best hidden qualities are, you realize that bonds have a lot to offer investors under 30.
So what are bonds? Why do old people love them? How to buy them and is it worth buying?
Let’s look at how to buy bonds.
What are bonds?
A bond is a loan. When you buy bonds, you are lending money to the organization you bought them from.
This is the main difference between bonds and stocks. When you buy shares, you are actually buying a stake in a company.
But when you buy bonds, you don’t own anything. You simply lend money to a government, city, or corporation, and they slowly pay you back.
How do bonds work?
Here is the short version:
- You are buying a bond.
- The bond issuer returns you the purchase price on the “maturity date”, i.e. the expiration date.
- In the meantime, the bond issuer also pays you interest on a regular basis.
I will give an example below, but in order for it to make sense, I must first cover some important terms.
Bonds have five main characteristics:
- nominal cost is the selling price of the bond.
- Coupon rate the interest you earn, expressed as a percentage of face value.
- Coupon date this is the date you will receive interest payments, usually every six months.
- maturity date is the expiration date of the bond.
- Issue price face value plus market adjustments and/or other fees.
Most bonds are sold “at par”, which means that the par value is equal to the same issue price (i.e. no additional fees).
Now, let’s say you buy a bond with a par value/issue price of $5,000, a coupon rate of 5%, and a maturity date of 2032.
Since your coupon rate is 5%, the bond issuer will pay you $250 per year or $125 every six months.
And if you hold the bond to maturity, the bond issuer will return $5,000 to you in 2032.
You can also sell your bond on the secondary market for a profit, although you will lose regular income and principal.
Why do people buy bonds?
People buy bonds for three main reasons:
1. Low risk
Bonds have an extremely low default rate, which means you going to get your money back. Even the most “risky” bonds (corporate bonds) have a default rate of just 0.40% in 2022.
The US government has only defaulted on bonds four times since the Civil War, not since 1971.
2. They provide a steady stream of income
If you buy enough bonds, you can essentially retire with the regular income they generate.
This is why, as people get older, they tend to move money from the stock market, where they are at risk, into bonds.
3. They are boring and predictable.
You may have heard that people buy bonds when the stock market looks bearish (i.e. not very good). This is because bonds are predictable and boring, which is exactly what you need if you want to survive a period of chaos and volatility.
People also like to buy bonds during a bear market because they know that the demand for bonds will increase and they can resell their bonds for a higher price, just like stocks.
Types of bonds
There are three main types of bonds: treasury, municipal and corporate. Here is a description of each, with their advantages and disadvantages:
US treasury bonds
US Treasury bonds are loans to the US government. You can buy them in $100 increments at TreasuryDirect.gov and see the latest prices here.
Source: TreasuryDirect.gov.
As you can see, Treasury bond rates tend to hover in the 3% range, meaning that buying $10,000 worth of bonds today will earn you $150 every six months until the bond matures (usually 20 or 30 years). with government bonds).
3% is… OK for bonds, but not great. But people still buy them because Treasury bonds are backed by the Treasury and have virtually zero default risk.
If you’re looking for a short-term bond with zero risk and a much higher interest rate, take a look at the Series I US Treasury Savings Bond. This is a special type of Treasury bond that matches inflation, so it pays an insane 9.62% through November 1, 2022.
Municipal bonds
Municipal bonds, also known as “municipal bonds”, are issued by a state, city, or county. These local governments are selling them to help fund parks, schools, libraries, etc. So there are some warm and fuzzy things to buy by buying municipal bonds and supporting your city.
Another advantage of municipal bonds over Treasury bonds is that your income from the latter is usually tax-free. You can also earn a little more; at the time of this writing, the interest/coupon rate on Chicago municipal bonds is about 5%.
The downside is that municipal bonds are more likely to default than Treasury bonds. Case in point: Detroit defaulted on its bonds in 2013. In addition, municipal bonds usually have to be purchased through a broker who charges a small percentage/commission. Finally, municipal bonds are typically sold in $1,000 increments.
But in general, municipal bonds are a great option if you want to invest in your city’s growth while earning a small recurring income.
Corporate bonds
Finally, corporate bonds are bonds that you buy from – you guessed it – corporations. And just like with municipal and treasury bonds, you will be giving money to corporations.
Corporate bonds pay more, but come with more risks and downsides.
- They start at $1,000 each.
- Some have floating interest rates.
- Almost all of them have a higher default risk than municipal or treasury bonds because if the company goes bankrupt, you may never see interest or principal payments.
So yes; even in the dull world of bonds, there is a high-risk, high-reward variant.
To learn more about the less common types of bonds (junk, foreign, etc.) and the risks associated with them, see How does a bond work?.
How to buy bonds
Buying bonds is not as easy as opening Robinhood and finding the ticker. Depending on the type of bond you are looking for, you have several options:
Direct from the government
The US government makes it pretty easy to buy bonds. After all, they want to sell them to you. So it’s no surprise that they have a pretty nice website.
Check out TreasuryDirect.gov. There you can buy bonds, manage your account and learn all about the variety of treasury bonds. This is a bona fide Amazon for government bonds.
Source: TreasuryDirect.gov.
From a brokerage/brokerage app
For municipal and corporate bonds, most investors work through a human broker or brokerage site such as TD Ameritrade.
TD Ameritrade even has a Bond Wizard that can help you find the bonds that suit your financial goals and needs.
And unlike buying bonds directly from the Treasury, buying bonds from a brokerage app allows you to enter both the primary and secondary markets. This means that you can buy bonds directly from the issuer at true par value, or buy them from other investors willing to sell their bonds either at a premium or below par, depending on how popular the bonds are.
Bond ETFs and Mutual Funds
Bond ETFs, such as Vanguard’s Total Bond Market ETF (BND), are like “baskets” of bonds that you can buy all at once. They can hold thousands of treasury, municipal, and corporate bonds, and you can buy a tiny slice of the entire basket for less than $100.
Bond mutual funds are similar to bond ETFs, only they are actively managed, which means that a team of professionals is constantly changing and optimizing their content.
Here are the benefits of ETFs/bond mutual funds:
- You can buy shares for less than $100.
- You can buy them just about anywhere that stocks and ETFs are traded (Robinhood, Public, etc.).
- They still pay out a regular income in the form of monthly dividends (so this is even more common than regular bonds).
But the main disadvantages of bond funds:
- Income is not fixed.
- There is no big principal payment at the end of the term.
- The value of bond ETFs can fluctuate more than the bonds themselves in the secondary market.
But overall, bond ETFs (and ETFs in general) are an excellent choice for young investors due to their convenience, low risk, and inherent variety.
Read more: How to invest in ETFs
What you need to know before buying bonds
If you’re tempted to mix some bonds into your portfolio, what else should you know ahead of time?
1. Know your risk tolerance and invest accordingly
Your risk tolerance is your financial and emotional willingness to accept losses in your portfolio. You can determine your risk tolerance in about five minutes by taking this short quiz.
Bonds are great for low risk tolerance, but if you are high risk tolerant, you can keep most of your capital in equities where it can grow faster.
2. Don’t chase maximum yield/interest rate
You may be tempted to sort bond options by highest yield/interest rate/coupon rate, but keep in mind that high interest rates are usually a direct reflection of the bond issuer’s risk of default.
The only fine exception to this rule is the link I.
3. If possible, talk to a specialist before buying.
The bond market is complex, so even experienced investors usually work through a broker or financial advisor.
To connect with one of them and discuss bonds, check out our guide to the best financial advisors for millennials and Gen Z.
Should you buy bonds?
If you have low risk tolerance, are approaching (early) retirement, and/or like the idea of getting a fixed income from your investments, bonds are a great choice.
If you’re a medium to high risk tolerant, don’t need a regular return on your investments (your day job pays very well) and prefer higher returns from the stock market, your portfolio is probably fine now without bonds. .
Also, you probably already have some – if someone else is managing your Roth IRA or 401(k), they’ve almost certainly mixed some bonds in there.
When in doubt, buy a bond ETF!
bottom line
Even if you don’t plan on buying bonds anytime soon, it’s great that you already know how they work at such a young age. Not only do they help you retire and live a great life, but they also help issuers build roads, hospitals, and more efficient companies.
Featured Image: eamesBot/Shutterstock.com
