An Introduction to Bond Investing: Types, Benefits, Tips & More

From time to time everyone could use extra money.

Bond investing is a way for you to help borrowers looking for more money, while also saving for the future and earning some extra income.

Bonds can be an important part of income investing for retirement or your investment portfolio and allow you to earn a passive income to supplement your salary.

But before you start purchasing bonds, it's important to have a clear understanding of what bond investing entails.

What Is a Bond?

Put simply, a bond is a loan made from an investor to a borrower.

Bonds are pieces of debt owed to investors that are issued by governments and corporations. Corporations use bonds to fund and grow their business; governments use the money to fund infrastructure and emergency spending, such as in the case of natural disasters or war.

Specifically, a bond is a type of asset known as a fixed income instrument. Bonds are bought for "par value"-usually $100 or $1,000-which sets the value of the bond when it reaches maturity. In exchange for purchasing a bond, you will get back the initial price of the bond on its maturity date, and you'll get paid interest in the meantime.

Bond interest rates vary depending upon the borrower's credit rating and the length to maturity of the bond. A borrower with poor credit is more likely to default but offers investors a higher interest rate and potentially a greater ROI. Similarly, the longer a bond takes to mature, the higher the bond interest rate since the investor is more likely to be subject to inflation.

What Are the Different Types of Bonds?

Investors looking to start bond investing have several options when adding to their portfolio, depending on the level of risk you're willing to take and how stable you want to make your portfolio.

Bonds are divided into two categories: investment grade and high yield bonds.

Investment-grade bonds are those issued by entities that receive high ratings from credit agencies and high yield bonds are those from lower-rated entities. Investment-grade bonds are deemed more likely to be paid back than high yield bonds, thus stabilizing your portfolio, but typically have lower returns.

Additionally, investors can trade bonds. Investors may want to buy bonds when the uncertainty of the stock market is high or there's added protection in the economy, which pushes the prices up, and yields down. If you own bonds during times like these, you can sell them and make a profit-just another reason why to consider bond investing.

There are also three primary types of bonds: municipal, treasury, and corporate.

Municipal Bonds

Bonds are issued by a town, city, or state are known as municipal bonds.

Municipal bonds are used for public works such as building and maintaining roads, schools, and hospitals. Municipal bonds average a 2.35% interest rate as of October 15, 2020. Interest earned from municipal bonds is tax-free and can be a good way to contribute to the community and make bond income.

Municipal bonds are further broken down into two categories:

  1. General obligation bonds are used to fund projects that don't generate revenue, such as public parks. Sometimes general obligation bonds are paid back by increasing taxes.
  2. Revenue bonds are used to fund projects that create revenue, such as a convention center. The money raised by the project is expected to be used to pay back revenue bonds.

Treasury Bonds

Bonds issued by the federal government are known as treasury bonds or t-bonds for short.

Treasury bonds are backed by the United States government and considered nearly risk-free. Because they are considered low-risk, treasury bond interest rates aren't as high. Currently,

30-year treasury bonds pay a 1.25% interest rate. Government bond interest rates on t-bonds are taxed federally but not at the state level.

Corporate Bonds

Bonds issued by companies hoping to expand their business or develop new products are known as corporate bonds.

Interest from corporate bonds is taxed but corporate bonds tend to offer the best yields of the three main types of bonds. The most recent IRS study shows an average of 4.01% interest rate on corporate bonds, but interest rates can vary greatly depending on the creditworthiness of the company issuing the bond.

Bond investing has two additional ways of allowing investors to earn income through bond interest in the form of less common bond types:

  1. Some of the highest-yield bonds are corporate junk bonds, which are issued by high-risk businesses. These bonds are considered below investment grade and, although they have the potential for higher bond dividends, are not recommended for the risk averse.
  2. Bond ETFs are simply mutual funds that invest in a variety of bonds, corporate, municipal, and treasury. Like any other ETF, bond funds provide exposure to more assets. Some funds will charge higher management fees than if you invest in individual bonds.

Bond ETFs

If bond investing has you struggling to decide which bonds you would like to purchase, perhaps a bond ETF is right for you. These exchange-traded funds are professionally managed and provide you with passive exposure to a variety of fixed-income assets.

The money managers who operate bond ETFs buy and sell bonds as they expire while attempting to track the performance of a major index such as the NYSE or NASDAQ.

When the fund collects interest from bonds, it is distributed to shareholders monthly. Capital gains made by the fund are paid out as part of an annual dividend.

Benefits of Bond Investing

There are several reasons to add bonds to your portfolio, let's take a look at some of the biggest benefits of bond investing.

Income Generation

No matter what type of bond you buy, your bond earns interest as it matures, providing you with a steady source of passive income.

Low Risk

If you're not purchasing junk bonds, bonds can be safer than stocks, especially US government bonds. Over long periods, stocks may outperform bonds, but bonds are great for diversifying your portfolio to hedge against stock crashes.

Capital Preservation

Buying bonds is like putting money into a savings account but you are less likely to pull the money out for a spur of the moment purchase. Money in bonds will be there for you in the future once the bond matures.

Community Contribution

Investing in municipal bonds helps build infrastructure and contributes to much-needed projects in your community. Not only are you earning a passive income, but you are also helping to make your community better.

Tips for Bond Investing

If you are looking to add a bond income to your growing list of income investing, there are a few tips you should be aware of to maximize your dividends:

Know How Comfortable You Are with Risk

If you are looking for safe investments, a t-bond could be the right move for you even though treasury bond interest rates are lower. On the other hand, if you are willing to take risks with the hope of bigger rewards, consider looking into corporate bonds or corporate junk bonds.

Be Aware of the Bond's Rating

A bond's rating lets you know the creditworthiness of the issuer of the bond. Higher ratings mean you have a better chance of having the bond repaid.

Take Note of When the Bond Matures

A bond's maturity date is the day on which the investment is repaid. Make sure you are comfortable with having that amount of money tied up in an investment for that long.

Talk to an Expert

When you decide to purchase bonds, set an appointment with a fiduciary whose specialty is in bonds. You can also follow Money Morning for all the latest market news. A fiduciary will be able to inform you of the latest market news and discuss your investment goals to point you in the right direction.

Get the Details

If you are looking at a high yields bond ETF, get acquainted with the bond portfolio. Make sure you are aware of the fees and what types of bonds make up the fund.

Key Takeaways

Bond investing is a good way for investors to earn a passive income while setting aside some money for the future. If you are looking to expand your portfolio, bond investing is certainly worth considering. Keep in mind:

  • Bonds are loans made from an investor to a municipality or corporation.
  • There are three major types of bonds-municipal, treasury, and corporate.
  • Interest on bonds is decided by the creditworthiness of the issuer and the length of maturity.
  • There are several benefits to bond investing, including low risk, a chance to improve the community, and hedging against uncertainty in the stock market.

Adding bonds or a bond ETF to your portfolio can go a long way to providing for a secure and comfortable retirement.

Continue reading our guide to income investing for retirement for more tips about making smart investments.

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