How To Buy Bonds: A Guide
For investors seeking reliable cash flow, bonds can be highly attractive. Learn where to go and what to consider before buying bonds.
Bond Basics
A bond is a fixed income investment in which an investor loans money to a corporation or a government. Returns from bonds are more predictable than returns from stocks, and they also possess higher return than money market funds. Bond yields are quoted on an annual return basis, but interest is most often paid in semi-annual coupons.
Not all bonds are the same. High yield bonds as well as bonds from emerging market countries, while often lucrative, carry more risk. Therefore, investors should do their homework before incorporating fixed-income investments into their portfolio.
In this article, we will outline how to make a bond purchase as well as other important considerations to assist in making an educated decision which matches your financial needs and investment style.
Where To Buy Bonds: 4 Methods
There are several methods by which investors can gain exposure to bonds:
- Directly from the U.S. Government
- With a brokerage
- Though a bond mutual fund
- Though bond exchange-traded fund (ETF)
U.S. Treasury
Investors can buy government bonds directly from the Treasury Direct website without having to pay a broker fee.
Some things to keep in mind before purchasing:
- You must be 18 years or older.
- You will need to provide a valid Social Security Number, a U.S. address, and a U.S. bank account.
- While U.S. Treasuries have a face value of $1,000, they are sold in $100 increments.
- There is no fee charged by the U.S. Treasury on such bond purchases.
Brokerage
Brokers offer a variety of bonds to investors, from corporate and municipal bonds to Treasuries, but the process is not as straightforward as buying from the government. In this scenario, you will be buying from investors looking to sell. Bond prices may differ from brokerage to brokerage, as they impose transaction fees, and at times, may institute markups or markdowns on the bid-ask spread. Therefore, investors should do their research on the various brokers like Fidelity, Charles Schwab, E*Trade and TD Ameritrade, to determine which one is right for them.
Bond Fund
Like a mutual fund, a bond fund is comprised of a pool of investor capital through which the fund is actively managed.
Benefits:
- This type of investment is often appealing to individual investors since it offers instant diversification without having to purchase many large, pricey units.
- Bond funds typically hire credit analysts to evaluate a bond’s credit quality, helping to limit investor risk substantially.
Drawbacks:
- Bond funds usually report their holdings semi-annually, though some report monthly. This can make it tough for investors to assess a bond fund's exposure at a particular time.
- While bond funds enable diversification at a lower cost, investors don’t have a set maturity date like in individual bonds; therefore, coupons can vary, and income is not guaranteed.
Bond funds are offered in two structures: open-ended funds and closed-ended funds.
Open-Ended Funds:
- Can be bought from fund providers, which means an investor doesn’t need a brokerage account to buy one; that way, the brokerage commission fee can be avoided.
- At the same time, bonds can be sold back to the company that issued the shares.
- Are traded and priced daily at what's called the net asset value (per unit).
- Since they do not trade at a premium or discount, it is easy to predict how much a fund’s shares will generate if sold.
Closed-Ended Funds:
- Are bought and sold in the open market and are re-priced continually based on trading supply and demand conditions for the fund.
- These can be trading at a premium or discount to the net asset value (or NAV) of the fund units.
- The NAV of a closed-ended fund's units is the per unit value of net assets (assets minus liabilities) held by the fund, calculated at the end of each trading day.
Bond ETF
Like bond funds, bond exchange-traded funds invest in a basket of bonds or debt instruments, but often, have lower fees.
Other characteristics of bond ETFs include:
- They function similarly to closed-ended funds in that they are solely bought and sold through a brokerage account instead of a fund company.
- An investor can easily buy or sell these on the open market.
- Share prices follow market movements and, therefore, have the potential to change in value dramatically during a crisis or rare event like the 2010 Flash Crash.
- Due to this fact, shares can trade at a premium, or, at a steep discount to the investor's purchase price.
- Reveal their underlying holdings daily. This complete transparency can be alluring to investors who want a good sense of where their investments stand at any given moment.
In some ways, bond ETFs offer more flexibility than open-ended bond funds. For instance, there is no penalty if an investor wishes to sell even shortly after purchasing a bond ETF.
Bond Funds vs. Bond ETFs
So, which type of pooled bond investment is better: bond funds or bond ETFs? The answer depends on the investment objective.
Bond Funds
- If you want to actively manage your investments, bond mutual funds offer more choices.
- If you are worried that you might not be able to sell due to a lack of buyers, a bond mutual fund may be more ideal since you can always sell your shares back to the issuer at the NAV value.
Bond ETFs
- If you wish to buy and sell frequently, bond ETFs could be the right fit for intraday traders.
- For investors who value transparency, bond ETFs provide you the ability to view holdings at any given moment.
For long-term investors who are open to riding out major market events, either bond funds or bond ETFs will work. But before committing to one, it’s crucial to do your research on the holdings of each fund.
What To Consider Before Buying Bonds?
There are several things to consider before purchasing a bond.
1. A Borrower's Solvency
Deciphering whether the issuing entity - company or government will be able to pay its debt obligations is paramount. Consider reviewing rating agencies, interest-to-income, grades and ratings, and more before moving forward with a bond purchase.
Rating Agencies
Bonds are rated by rating agencies which can be helpful in determining a borrower's solvency. The three biggest rating agencies in the industry are:
- Moody’s
- Fitch
- Standard & Poor’s
By following their guidance, you can get a sense of their payment capabilities. The higher the rating, the more confidence you can have that a government or company that issued bonds will honor its obligations.
ETF Grades & Quant Ratings
Seeking Alpha's ETF Grades is another tool that helps filter ETFs. Its Quant grading system captures, filters, and scores numerous ETF data points into five categories: Momentum, Expenses, Dividends, Risk, and Asset Flows. Its Risk Grade, particularly, is a sophisticated measure that sizes up various risks - portfolio, liquidity, concentration, volatility, trading, tracking error, and short-interest - all in a single grade that allows users to see where the ETF stands as compared to others in its asset class.
Interest-to-Income
Another way to determine whether a corporation is likely to repay its debt, is to find out how much interest it pays relative to its income. This can be found via income statements. If the company doesn’t have the income to support payments, you can expect trouble. Finding out the status of government bonds is somewhat trickier, since they don’t maintain excess revenues the same way firms do. In this scenario, it will be best to rely on credit ratings. For instance, U.S. Treasuries are considered the safest in the world. They're currently rated AAA (negative outlook) by ratings agency Fitch, Aaa (stable outlook) by Moody's and AA+ (stable outlook) by S&P.
Municipal bonds, on the other hand, are not as secure as those issued by federal governments. Still, you can refer to a country’s credit rating to get an understanding of what its municipalities are able to pay lenders. Another place for guidance is the Electronic Municipal Market Access (EMMA) site. It is the official source for municipal securities' data (price, ratings, trends, etc.) and documents, with a state breakdown of tools and resources as well as market activity.
2. What Drives Bond Prices?
Bond prices have an inverse relationship to interest rates. When interest rates go up, bond prices tend to drop; when interest rates drop, bond prices go up. At first, this may seem counterintuitive, but it actually makes sense once you take a closer look.
One way to make sense of this inverse relationship is to consider zero-coupon bonds as they don't pay regular interest. Instead, they achieve value from the difference between a purchase price and par value paid at maturity. These types of bonds are issued at a discount to par value but remain attractive to some investors because they lock in a bond's yield.
Let's say an investor buys a zero-coupon bond with a return rate of 5%. This implies that he or she is content with receiving a 5% return. But imagine that interest rates were to rise, meaning that newly issued bonds could generate 10% yield; that zero-coupon bond would suddenly be far less attractive. To attract investor demand, the price of the pre-existing bond would have to drop to match the same return generated by existing rates. The same thinking holds true when interest rates decline. Say they were to fall to 2%, the zero-coupon bond would appear much more appealing compared to the broader bond market.
3. Coupon Rate vs. Bond Yield
All this talk of coupon rates and bond yields may have you wondering what's the difference.
- The coupon rate is the rate of interest a bond pays each year. It is delineated as a percentage of its par value. Therefore, a $1,000 bond with a coupon rate of 5% pays $50 interest each year.
- Bond yield is essentially the rate of return the bond generates for the investor on the purchase price of the bond. So, if the $1,000 par value bond was bought by the investor at $950, the bond would generate 5.3% yield ($50/$950*100).
4. Timing of a Bond Purchase
Once a bond’s interest rate is set and made available to investors, the bond trades on the debt market. The moves of other interest rates on the market then affect how the bond’s price changes. Typically, as the economy expands, interest rates go up which brings bond prices lower. As the economy shrinks, interest rates fall, which lifts bond prices higher. Since fluctuating interest rates make the timing of bond purchases challenging, bond investors tend to buy bonds that mature across a period of years and then reinvest them once they have reached maturity. This strategy helps minimize risk, but it also means investors could miss out on the highest possible yield.
5. Which Bond is Right For You?
Several factors will determine whether a bond is right for you such as:
- Your desired income from the bond
- Your appetite for risk
- Your tax situation
Furthermore, you may want to consider a mix of different bond types. To what extent would you like to have corporate, municipal, or federal bonds? To reduce interest rate risk, you can choose bonds with different maturities as well. Since bonds are typically sold in $1,000 increments, it can be a challenge to build a diversified portfolio.
Another option is to buy bond ETFs, which provide instant diversification, and you can even select various bond ETFs to add another layer of variety.
Lastly, you should demarcate your desired return time frame, to assess the right addition to your portfolio.
Bond Examples
- Let's say you buy a $5,000, 6-year corporate bond paying a rate of 5% per year, semi-annually directly from a brokerage. Assuming you hold the bond through its maturity date, you will get 12 payments of $125 each, or a total of $1,500. If you want to sell, you can sell it back to the original brokerage at any time at market value. The 5% coupon represents $250 of interest on $5,000 invested in bonds.
- By contrast, say you bought a short-term Treasury (T-bill) from the U.S. government. Since they are sold at a discount from their Net Asset Value (per unit), investors receive the full-face value at maturity. For example, let's say you bought a T-bill for $950, you'll receive $1,000 at the bill’s maturity. Similar to a corporate bond, investors can sell Treasuries easily in the secondary market.
Are Bonds a Good Investment?
When it comes to bonds, there is no one-size fits-all approach. Similar to stocks, there are a variety of bond types available to investors. Additionally, each investor will want to consider his or her own personal needs and investment style. Typically, investors who desire a more stable cash flow, will seek bonds issued by corporations and governments with high revenues. These types of bonds can help diversify an investor's portfolio and hedge against risk already present in their holdings. Certain bonds can also be appealing to investors with a high appetite for risk, like government bonds from emerging market countries and corporate bonds from less secure companies. Junk bonds as well as those from emerging markets can, at times, deliver high payouts.
Like stocks, bonds issued by more stable governments, will be priced higher due to greater investor certainty, but investors can be assured that they will receive a certain amount of income every year. For investors who want a predictable, safe inflow of cash, that can prove highly attractive. Meanwhile, buying debt from an emerging market, though substantially risky, has the greatest chance of delivering high returns. The same holds true for corporate bonds. Companies with excellent credit ratings issue investment-grade corporate bonds, but they offer lower yields; corporations with lower credit ratings have the greatest chance to deliver high returns.
As something else to consider, corporate bonds tend to hold up across most economic environments, except a rising-interest rate environment. This stability comes at the expense of lower long-term returns. Still, even the most robust firms can suffer hardship at the heels of a sudden economic crash. Investors who want exposure to a corporation may be better off investing in its stock, especially if they’re able to stay in for the long haul.
At the end of the day, your biggest decision is whether to add debt exposure in the first place, and secondly, what level of risk is acceptable. These considerations will establish which bond investment is right for you.
This article was written by
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