While bonds are relatively low risk, no investment is 100% risk free. Risks associated with bonds include:
- Low interest rates: Bonds typically provide relatively low rates of return. Interest rates can be higher for longer-term, or higher risk bonds, but may still be less than other investment products.
- Hard to keep up with inflation: High rates of inflation can reduce the value of any interest payments you earn. For example, if a bond pays a 4% interest, but inflation is 3%, the bond's real rate of return is only 1% when adjusted for inflation.
Bonds can be purchased through an online brokerage account or directly from the issuing government or corporation.
How you buy bonds will usually depend on the type of bond you’re looking to buy.
Buying Individual Bonds
Individual bonds can be purchased directly from the government or corporation that issues them.
You’ll need to work with a financial institution, brokerage or other financial advisor as individual some bonds aren’t traded directly on the stock market. A broker can help purchase the bond on your behalf. Your broker may charge a commission to purchase the bond, and a separate commission if you need them to sell the bond before it matures.
The process for buying individual bonds is more or less the same regardless of whether you’re buying bonds from a government or a corporation.
Buying Bond Mutual Funds
Buying bond mutual funds is similar to buying stocks via the discount brokerage. You decide how many shares of the fund to buy and place your order. Unlike buying stocks, orders to buy bond mutual funds are only executed once per day after the market closes.
Bond mutual funds include a diversified portfolio of bonds. They’re also professionally managed. When you buy a bond mutual fund, you’re pooling your capital with other investors. Instead of owning 100% of a small number of individual bonds, you’re buying shares in a fund that could include hundreds of separate bonds.
Bond mutual funds often target a specific type of bond and will be actively or passively managed. Instead of paying a commission, you’ll pay a management fee to the fund manager. Management fees are typically listed as an “expense ratio” based on how much you invest each year. So, if you invest $1,000 and your fund charges a 1% expense ratio, you’ll end up paying $10 per year.
You’ll usually have the option of receiving monthly payouts or re-investing any earnings back into the fund.
Buying Bond ETFs
You can also purchase bond exchange traded funds (ETFs).
Like bond mutual funds, investing in an ETF lets you buy a portion of individual bonds held within the ETF.
ETFs offer a cost-effective way to invest in bonds. Minimum investment thresholds are typically low – making bond ETFs more accessible to a wider range of investors. Management fees for ETFs can also be relatively lower than individual bonds.
Bond ETFs offer regular payments, just like bond mutual funds, but orders can be placed at any time of the day.
New Issue Bonds
New issue bonds are bonds purchased on the primary market when they’re first issued. It’s like buying a stock as part of a company’s Initial Public Offering (IPO).
Secondary Market Bonds
Bonds can be purchased directly from the government or corporation that issues them or bought on the secondary market. Bonds become available on the secondary market when the original bondholder decides to sell an existing bond prior to it reaching maturity.
Bonds sold on the secondary market can include markups on their original purchase price, commissions and other transaction fees. You may also see the same bond offered at different prices by different dealers.
Bond Ladders
Bond laddering is a strategy used by investors to help manage risks posed by volatile interest rates.
You build a bond ladder by purchasing a number of individual bonds with different maturity dates. That way, you avoid locking your investment into a single interest rate.
When a bond at the beginning of your ladder matures, you reinvest the principal back into a newlonger-term bond. If interest rates have gone up since you first invested, you’ll benefit from reinvesting at higher rates. If interest rates have gone down, your existing bonds will still be locked in at higher rates until they mature.
It’s usually best to build bond ladders with high-quality, and more reliable, bonds.
