Updated on 08.09.17

All About Bonds: How They Work and When to Buy Them

Often overlooked as the stock market's trusty sidekick, bonds play an important role in your portfolio.

Stocks get most of the play when it comes to investment news, books, and articles, with bonds typically playing the role of the sidekick.

But bonds are an important part of your portfolio, and the bond market is both larger than the stock market and arguably more complex (as anyone who has read or watched The Big Short knows).

And while you don’t need to be an expert on the entire bond market, having a basic understanding of what bonds are, how they work, and how to use them will help you make better investment decisions.

What Are Bonds?

A bond is simply a loan in which you are the lender and the company or organization that issues the bond is the borrower.

Each bond specifies an amount of money to be borrowed (the principal), a date on which the bond will be paid back (the maturity), and an interest rate to be paid in the meantime.

For example, a company might issue a $1,000 bond that pays 5% interest for 10 years. When you buy the bond, you are loaning the company $1,000 that they can use in their business. In return, you receive $50 in interest every year for 10 years, and once that period is up you will get your $1,000 back.

In a way, you are investing in the company. You’re essentially making a bet that the company will perform well enough to be able to pay back your loan with interest.

But unlike buying stock in the company, buying a bond does not make you a part-owner. You are simply a lender, which comes with both advantages and disadvantages.

The Pros and Cons of Investing in Bonds

Because they’re loans, bonds play a completely different role in your portfolio than stocks. Here are some of the advantages that bonds offer over stocks:

  • Regular income: While many stocks pay dividends, those dividends are typically optional and can fluctuate up and down depending on the company’s profits. Bonds, on the other hand, provide consistent and dependable income in the form of the interest payments that are a required part of the loan agreement.
  • Bankruptcy preference: If a company goes bankrupt, bondholders are paid back before stockholders. This is one of the big reasons why bonds are considered a safer investment.
  • Less risk: Bond prices typically fluctuate much less than stock prices. You can certainly lose money in the bond market, but those losses are usually much smaller than what you experience with the stock market.

But no investment is perfect, and bonds have their share of downsides as well:

  • Less upside potential: With less risk comes less return. Given that you are simply a lender, and not an owner, you don’t have the potential for the really big returns that stocks can sometimes provide.
  • Risk: While bonds are typically less risky than stocks, you can still lose money. Interest rates could rise, making your bond with a lower interest rate less valuable. The company might go bankrupt and not be able to pay you back. Your bond might be called early, leaving you without the regular income you expected. Typically, longer term bonds are considered more risky simply because there’s more time for things to go wrong.

As with stocks, diversifying your bond portfolio allows you to take advantage of the overall benefits bonds provide without taking on the unnecessary risk of any one bond ruining your portfolio.

The Major Types of Bonds

The bond market is incredibly diverse, with many different types of bonds constructed in many different ways. It would be impossible to cover all the different variations here, but there are some major categories that are worth understanding when choosing bonds for your personal investment portfolio.

1. Treasury Bonds

Treasury bonds are issued by the United States federal government and are the largest sector of the U.S. bond market.

Treasury bonds are also generally considered to be the safest type of bond. With the full backing of the U.S. government, the general consensus is that there is almost no risk of these bonds not being paid back. The flip side is that the interest rates are typically lower than other bonds that come with more risk.

Given this low-risk, low-return dynamic, Treasury bonds are particularly effective as a pure hedge against a stock market crash. Including them in your portfolio won’t make you rich, but they do provide a buffer that should keep some of your money safe even in the worst of times.

2. Corporate Bonds

Corporate bonds are issued by companies rather than the government. They vary widely in both the level of risk and the interest rate offered, largely depending on the strength of the company issuing the bond.

One way to gauge the level of risk in a bond is to review the bond’s credit rating. These ratings are far from perfect, but they can help you get a sense for how likely the company is meet the terms of the bond.

Corporate bonds can be a good middle ground that allow you to benefit from the more conservative nature of bonds without sacrificing as much in the way of returns. But the more you reach for return with your bonds, the more risk you’re taking on, and the less effective your bonds are in balancing out the stock portion of your investments.

3. Municipal Bonds

Municipal bonds are issued by local governments, from states all the way down to towns and other governmental agencies. They function much like other bonds, with two unique characteristics:

  1. The interest is often tax-free for federal income tax purposes.
  2. The interest can also be tax-free for state and city income tax purposes, if you live in the state or city that is issuing the bond.

Those tax characteristics can make municipal bonds particularly attractive for high-income investors who live in high-tax cities or states and are investing within a taxable account. You might sacrifice something in the form of lower interest rates, but the tax breaks can lead to a better after-tax return.

How to Invest in Bonds

Like stocks, you can choose to buy individual bonds or you can invest in mutual funds and ETFs that pool many bonds together in a single investment.

Most brokerages allow you to buy and sell individual bonds, and you can also buy Treasury bonds directly from the federal government. Certain investment strategies, such as liability-driven investing, rely on purchasing individual bonds, but for the most part buying individual bonds is fairly risky due to the lack of diversification and the difficulty of knowing which bonds will outperform.

A simpler approach is to buy mutual funds or ETFs that invest in a wide variety of bonds for you, making it easy to diversify. You can even take an index investing approach with your bonds, allowing you to capture the return of the entire bond market at a minimal cost, which is both easier and more likely to succeed than most other strategies.

Use Bonds Wisely

When you are years away from retirement, bonds primarily serve as a safety valve for your portfolio, balancing out some of the risk of the stock market and making for a smoother ride.

When you’re nearing or in retirement, bonds can serve as more of a driving force in your portfolio, generating reliable income and reducing the risk of a big loss right when you can least afford it.

Either way, understanding bonds and using them wisely can make it easier to reach your investment goals.

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.

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