Learning how to buy bonds is an essential part of your education as an investor. A well-diversified investment portfolio should strike a balance between equities and fixed income, letting you ride out volatility while capturing growth along the way. Let’s take a closer look at the basics of buying bonds.
Why Invest In Bonds?
Bonds tend to offer a reliable cash flow, which makes them the good investment option for income investors. A well-diversified bond portfolio can provide predictable returns, with less volatility than equities and a better yield than money market funds. Even when interest rates are low, bond investing options like high-yield debt or emerging market bonds can meet an investor’s need for income, although with substantially more risk.
“The purpose of fixed-income investments is to add diversification to a portfolio,” says Rich Powers, Head of ETF Product Management at Vanguard. “If you look at the return of the U.S. stock market this year, stocks are down roughly 13%. U.S. investment-grade bonds are up a little more than 4.5%. That’s important because if an investor holds a balanced portfolio of stocks and bonds, that helps them have a less volatile investor experience.”
How to Buy Individual Bonds
Investors can buy individual bonds through a broker or directly from an issuing government entity. One of the most popular cases for buying individual bonds is the ability for investors to lock in a specific yield for a set period of time. This strategy offers stability, whereas the yield on a bond mutual fund or fixed-income exchange traded fund (ETF) fluctuates over time.
It’s important to keep in mind that individual bonds must be purchased whole. Most bonds are issued in increments of $1,000, so you need to fund your brokerage account balance with at least that amount to get started. Note that while U.S. Treasury bonds have a face value of $1,000, the minimum bid is $100 and they are sold in $100 increments. U.S. Treasury bonds can be purchased through a broker or directly at Treasury Direct.
Whether you’re exploring how to buy municipal bonds, corporate bonds or treasuries, the basics of buying an individual bond remain the same: You can purchase them as new issues or on the secondary market.
New Issue Bonds
Buying new issue bonds means you’re buying bonds on the primary market, or the first time they’re issued, similarly to buying stock in a company’s IPO. Investors acquire new issue bonds at what’s called the offering price.
How to Buy Corporate Bonds as New Issues
For everyday investors, it can be tricky to acquire new issue corporate bonds. You’ll typically need a relationship with the bank or brokerage that’s managing the primary bond offering. When considering corporate bonds, you should understand the bond’s rating (investment-grade or non-investment grade/junk bonds), maturity (short-, medium- or long-term), interest rate (fixed or floating) and how the coupon (interest payment) is paid (regularly or zero-coupon). To complete your purchase, you’ll need a brokerage account that will cover your purchase price and any commissions your broker might charge on the acquisition.
How to Buy Municipal Bonds as New Issues
Buying municipal bonds as new issues requires an investor to participate in an issuer’s retail order period. You’ll need a brokerage account directly with the financial institution backing the bond issue and complete a request that indicates the quantity, coupon and maturity date of the bonds you want to purchase. You can find the available coupons and maturity dates in the bond prospectus, which is given to prospective investors.
How to Buy Government Bonds as New Issues
You can purchase government bonds like U.S. Treasury bonds through a broker or directly through Treasury Direct. As noted above, treasury bonds are issued in increments of $100. Investors can buy new-issue government bonds through auctions several times per year, by placing a competitive or a non-competitive bid. With a non-competitive bid means you’ll accept the terms set by the auction. When placing a competitive bid, you can indicate your preferred discount rate, discount margin or yield. You can track upcoming auctions online.
Secondary Market Bonds
Bondholders often sell their bonds prior to maturity on the secondary market. If you’re interested in learning how to buy bonds that aren’t new issues, you can buy all the above types of bonds on the secondary market. Purchases are made via a brokerage, specialty bond brokers or public exchanges.
When buying bonds on the secondary market, you’ll need to do more research because pricing is less transparent. With new issues, all buyers pay the same price. On the secondary market, there can be a markup on corporate and municipal bonds. It’s also entirely possible to see the same bond offered by two different dealers at two different prices. You may also be charged commissions, transaction fees and contract fees on your bond-related transactions.
If you’re committed to buying individual bonds on your own without an investment adviser, you can research fair pricing for municipal bonds using Electronic Municipal Market Access (EMMA). For corporate bonds, you’ll need to perform a price comparison for bonds you’re considering to make sure you’re comfortable with the spread a broker is charging prior to purchase.
Treasury bonds aren’t offered on the secondary market by the government, but can be purchased via brokerages.
Building Bond Ladders
When buying individual bonds, some investors want to manage their interest rate risk by spreading out the maturity dates for the bonds they hold. This is referred to as “bond laddering.” Fixed-income investors use bond ladders to provide additional flexibility adjust their holdings to changing market conditions.
For example, you might have $15,000 to invest in bonds. You could spend it all on a single bond with a 10-year maturity date, but your capital would be tied up for a decade—plenty can change in markets in ten years. With a simple bond ladder, you would purchase three $5,000 bonds with staggered maturity dates: One year, two years and three years, for instance.
As each bond comes to maturity, you reinvest the principal in bonds with the longest term you chose at the outset—a 3-year maturity in this case. With this simple bond ladder, you would have $5,000 to reinvest each year. If interest rates are higher, you gain the advantage of better yields. If they’re lower, the ladder still includes maturities locked in at higher yields. Plus, you can stagger coupon payments to improve cash flow.
Challenges of Buying Individual Bonds
When thinking about how to buy bonds for your investment portfolio, individual bonds offer several challenges. In addition to the wide range of moving parts inherent in each bond, the primary market can be difficult to access for all but the wealthiest investors. The secondary market has less transparent pricing than primary issues, which makes it difficult for investors to know the true cost of individual bonds and how much markup is built into the cost.
If individual bonds seem too complex for your level of investment savvy and you don’t want to use a financial advisor for guidance, you can explore two additional ways to add fixed-income instruments to your investments: bond mutual funds and bond ETFs.
Buying Bond Mutual Funds
Bond mutual funds offer investors many of the benefits of individual bonds, with decreased risk. Plus, buying mutual funds is a much simpler process.
“Some of the key features of bond mutual funds are the benefit of diversification and professional management,” says Powers. “With a bond mutual fund, investors get the benefit of fixed income professionals managing the money and being in a pooled fund where they’re not holding just ten individual bonds. They’re holding hundreds of bonds where the likelihood of one bond disproportionately impacting your results is much lower.”
Like a stock mutual fund, bond mutual funds let you pool money with other investors to buy shares of a portfolio of bonds. Bond mutual funds may be actively or passively managed, funds typically follow a particular type of bond—corporate or municipal. They tend to pursue a set maturity strategy, long term or short term.
Some of the benefits of bond mutual funds include:
- Liquidity:You can buy and sell shares of bond mutual funds as easily as buying shares of stock. Unlike stock, orders to buy mutual fund shares are executed once per day, after the market close.
- Dividend reinvestment:Funds make it easy to reinvest your income payment dividends back into the fund to keep building your investments.
- Regular income:As an alternative to reinvesting dividends, most bond funds give you the option to receive monthly payouts, providing a steady stream of cash for investors who want the income benefits of bonds.
- Possible tax-free income:Depending on your tax bracket and stage of life, investors might opt for municipal bond funds that offer the potential for tax-free income. In general, interest paid on munis is exempt from federal income tax and may be exempt from state and local taxes.
Bond mutual funds will come with management fees to compensate the fund managers for actively managing the bonds bought and sold within the fund. This fee is expressed as an “expense ratio” and indicates the fees you’ll incur based on your investment each year. For example, a bond fund with an expense ratio of 1% will charge you $10 per year on your $1,000 investment.
Many bond mutual funds have minimum initial investments which you’ll want to note. These minimums can differ between regular brokerage accounts and qualified accounts like IRAs.
Buying Bond ETFs
You can invest in bonds by purchasing bond exchange traded funds (ETFs). Like bond mutual funds, ETFs comprise baskets of bonds that follow a particular investment strategy. Bond ETFs may also be passively or actively managed. ETF fees are typically lower than bond mutual fund fees.
“By and large, ETFs are very low cost, and investors can keep more of the returns for themselves instead of paying a manager’s fees as with a mutual fund,” says Powers. “For a newer investor or someone with less money to invest, the threshold of entry is just the NAV cost of the ETF instead of the initial investment minimums with many mutual funds.”
Besides cost, ETFs offer even greater liquidity. Shares of ETFs trade like stocks during regular market hours, rather than only once a day with mutual funds. Like bond mutual funds, bond ETFs offer regular income payments.
When trying to decide how to buy bonds, a bond mutual fund might be a better solution for investors who plan on holding the fund shares for an extended period of time. More active investors might prefer bond ETFs since there aren’t short-term redemption fees charged by many mutual funds to discourage excessive trading.
The Bottom Line
Buying bonds, whether individual bonds, bond mutual funds, or bond ETFs, provides diversification and reliable income for your investment portfolio. With all bond-related investments, you must do your due diligence: Research issuers, compare ratings, and if possible, consult with your investment professional to help guide your choices.
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“How to Buy Bonds: A Primer for New Investors” was originally published by Forbes Advisor, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.