Do you want to have a diversified portfolio? Bonds are a crucial part of that. Here’s how to invest in bonds.
Bonds generate passive income and are important to add to your portfolio, depending on your personal preference. Here’s everything you need to know about bonds and how to invest in bonds.
What is a bond?
A bond is a way to raise money by corporations or governments. When you buy a bond, you buy a part of a loan with the promise to repay this loan to you plus a certain percentage of interest.
Government bonds are the most known form of bonds. With these bonds, a government wants to take a certain loan from the market to finance their expenses. However, public companies can also issue bonds. The concept is the same. They need money, they ask the market for money, and the market provides.
Bonds a rated by third-party agencies, also called credit agencies, to help you determine the risk you take with bonds. A better rating implies that there is a higher chance of getting your initial investment back.
What Types Of Bonds Are There?
Bonds exist in a variety of forms; here are the most common forms:
- Corporate bonds are a way of raising money as a company. Bonds issued by corporations generally give a higher interest rate because of the higher risk.
- Municipal bonds are issued by local governments to fund public projects. It can be projects like roads, parks, and more.
- Treasury bonds also called government bonds, and are issued by the government of countries. They carry lower risk, which is why you get a lower interest rate for these bonds.
- Bond funds are mutual funds that invest in a diversified portfolio of bonds. These bond funds are actively managed, which means high management fees and commissions if you decide to buy them.
How Can You Make Money With Bonds?
You can make money with bonds in two ways:
- The company or government that issues the bond has to pay a certain percentage interest to the bond owners. Let’s say you get 3% interest on a $1000 bond, so you get $30 yearly interest. At the maturity date, you will get an additional $1000 for your initial investment.
- Selling your bonds at a higher price. Why would bond prices increase? If the interest rates on new bonds decrease, your bond with higher interest rates increases. If the company or country you borrowed your money to increases their credit rating, your bond increases in value. The likelihood of the borrower paying back the money increase.
Pros Of Investing In Bonds
- Bonds are generally less risky than stocks. The value of bonds doesn’t change as much as the value of stocks. It means that bonds are a good way to preserve capital when you are further in your investment journey.
- The percentage of interest (return on your investment) is fixed. Bonds have a fixed income stream that gets paid at regular intervals.
- You want to diversify your portfolio. Even though stocks outperform bonds historically, it is good to diversify your portfolio to reduce your risk. Stocks and bonds generally have an inverse relationship, so bonds go up in value when stocks go down.
Cons Of Investing In Bonds
- Bonds mean that you buy an asset in exchange for your cash. It means that you have less liquidity in your portfolio. As a consequence, your liquid net worth could decrease.
- Bonds generally have a lower return on investment. Stocks return on average 7% return per year, while you get much lower returns with bonds. Especially now the interest rates are low, the difference will be bigger.
- The risk that the interest rate changes. We currently have historically low interest rates. When the interest rates go up, the value of the current bonds decreases.
- There is an inflation risk, where inflation can rise more than the return you get from bonds. When that happens, you lose purchasing power.
How To Invest In Bonds?
How will you trade bonds? Most brokers offer access to the stock- and bond market, which means you can trade bonds just like stocks. You don’t have to wait until the maturity of your bond to receive your money. Just like stocks, the value of bonds is determined by the market.
If you want to invest in the bond market, you have a couple of options.
1. Invest Directly Through The US Treasury Department
You can buy U.S. bonds directly from Treasury Direct, where you need to be at least 18 years old and need a valid US address plus social security number.
If you want to buy individual bonds, you have the risk of less diversification. Also, if you want to sell your bonds before maturity, it could become complicated.
When you don’t have a financial advisor, bond mutual funds, or bond exchange-traded funds (ETFs) would be a much better option.
2. Invest Through A Mutual Fund
When you want to diversify your bond portfolio, you can buy a bond fund. You can diversify your investment. There is active professional management of these funds.
When you choose bond mutual funds, your funds will be actively managed, and the management costs will be higher.
You can trade in the mutual fund once per day, which increases liquidity compared to buying individual bonds. If you want to consider this option, you have to be aware of the minimum initial investment and the specific costs associated with the mutual fund you want to consider investing in.
3. Invest In A Mutual Fund Or ETF
When you want to diversify your bond portfolio, you can also buy a bond ETF. You can diversify your investment for a lower cost. There is passive management of the funds.
When you choose bond ETFs, your funds will be passively managed, and the management costs will be lower.
A major benefit of a bond mutual fund or ETF is that you can sell your bonds when you want. It increases the liquidity of your investments because you can sell them at any moment.
Should I Invest In Bonds?
There are a couple of scenarios where it could be wise to invest in bonds:
- If you’re risk-averse and don’t want to lose money, investing in bonds is for you.
- When you are 100% invested in stocks, you can diversify your portfolio by investing in bonds.
- You are getting closer to retirement age, and you want to decrease your risk because you have little time to make up for economic downturns. As you get older, it may be wise to shift more of your portfolio from stocks to bonds.
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