Beginner's Guide to Investing in Bonds

What is a Bond?

A bond is a type of fixed income investment, which is an investment that is considered a low-risk asset, but one that provides a fixed stream of income through interest or dividends. This assists in answering some of the most common questions for those who may be interested in adding bonds to their portfolio, but still wonder, "what are bonds?" or "how do bonds work?"

When you buy a bond, you are lending money to another entity. The borrower on the other end of the bond is frequently a municipal, state, or federal government body, or a private entity (like a hospital raising funds to complete a project).

The “fixed” of fixed income refers to the schedule and payments - you know ahead of time how much interest you’ll be getting and when. The borrower is promising to pay you back at a set time in the future with interest payments along the way.

Bonds can add diversification to your investment portfolio by granting investors another option when looking for alternative assets. Bonds are generally lower risk and lower return than equity (stock) investments and can reduce the volatility of a heavily stock-focused portfolio.

Types of Bonds

There are various bond examples investors would want to be aware of before jumping in with both feet. The bond market and how to navigate the many types of bonds investments out there can be confusing. Let's go through some of the most common types here:

International Bonds

An international bond is a bond issued by a country or company that is not domestic for the investor. For example, a U.S. investor may buy a bond issued by a German company in Euros. For the Germany company this is a domestic bond, and for the U.S. investor, it is an international bond.

Investors benefit from portfolio diversification by adding international bonds to their portfolios. International bonds provide exposure to other countries and their economic conditions.

A U.S. investor whose portfolio includes bonds issued in Asian countries will benefit when Asian economies are doing well, even if the U.S. economy is suffering. A portfolio that includes international bonds from a range of countries and regions will be relatively insulated against economic downturns in any particular part of the globe.

When it comes to the potential risks of investing in international bonds, here are some of what investors need to watch out for. International bonds are denominated and pay interest in a foreign currency, so their value fluctuates with the economic conditions in the issuer’s country, and with the exchange rates between the investor’s and issuer’s countries.

That means that these bonds are subject to currency risk, or exchange-rate risk. Currency risk is the potential for change in the relative price of two currencies in relation to each other. The bonds may also be subject to different regulations and taxation requirements than the investor is used to.

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Municipal Bonds

Municipal bonds are financial vehicles for communities to build schools, fix highways, improve water systems, maintain bridges and tunnels, upgrade hospitals, and more. Municipal bonds are a means for investors to loan money that funds local infrastructure and public works programs. In short, when a municipality needs to raise money for an infrastructure project, they often issue bonds. These bonds fund a project over a designated period of time.

During that scheduled period of time, investors are paid interest (typically semi-annually) until the bond matures, at which time they receive their initial principal back. There are two types of municipal bonds, a general obligation (GO) bond and a revenue bond.

A GO bond is usually backed by a municipality’s local government and carries an unconditional promise of repayment. GO bonds generally pay investors via a general fund or through a dedicated local tax. Revenue bonds fulfill debt obligations via raised money. For example, a bridge that collects a toll or a sporting facility that raises money via ticket sales.

Municipal bonds tend to help buffer portfolios as the stock market fluctuates. Municipal bonds are unique in that they offer both tax-exempt income and high credit quality. They have particular appeal for income-oriented investors in higher tax brackets who want to reduce federal and state income tax bills.

The municipal bond tax exemption makes them attractive enough that investors often choose them over their corporate counterparts.

Municipal bonds, or "Muni" bonds also carry some potential risks investors want to be aware of. Municipal bonds tend to be less liquid than their corporate counterparts, which investors should consider before investing.

Short-Term Bonds

What is a short-term bond? Short-term bonds have a maturity date of less than five years. Any entity can issue short-term debt, including all levels of government (federal, state, local), as well as corporations. A short-term bond fund is a fund that invests in short-term bonds.

A short-term bond fund’s portfolio may include things like variable-rate corporate and real estate debt, taxable municipal bonds, packages of car loans and credit card bills, revolving equity credit lines, and even soon-to-mature junk bonds.

Why would investors be interested in investing in short-term bonds? Short-term bonds are low risk. They tend to have lower interest rate risk than intermediate- or long-term bonds. That’s because the shorter maturities normally translate to a lower risk of losing some of your principal. Short-term bonds offer predictable income.

The yield of the fund’s portfolio is known on a daily basis and bonds are attractive because of the promise of repayment of your original investment at maturity.

Short term bonds also offer a potentially higher yield than money market funds. A portfolio mix with a wide variety of bonds is why short-term bond funds offer higher yields than money market funds—anywhere from 0.5%–2%, depending on their underlying investments—and this can add up over time.

Like any investment, short-term bonds aren't without their risks, as well. Short-term bonds are highly sensitive to expectations for interest rates. If the markets expect the Federal Reserve to raise interest rates in order to combat inflation, then the yields on shorter maturity bonds (such as a 2-year Treasury note) will quickly rise to meet those expectations.

The end result is a drop in the share price of the bond fund, although its drop will be less than that for bonds funds holding longer maturity bonds. That provides a better ratio of return for the risk taken.

Treasury Bonds or Government Bonds

You may have heard a lot about Treasury bonds, and all bonds for that matter lately, as the government announces they will be continuing with quantitative tightening (QE), or reduction of the Fed's balance sheet.

U.S. Treasuries come in maturities ranging from one month to 30 years. Short-term Treasuries are called Treasury bills (from one month to one year); intermediate term Treasuries are called Treasury notes (two year, three year, five year, seven year and ten year); longer term Treasuries are called Treasury bonds (30 years). Treasury bills are non-interest-bearing. Instead, they are bought at a discount to face value (par) and investors are paid the face value when the bills mature.

Treasury notes and bonds pay interest on a semi-annual basis. The principal is paid back when the note or bond matures. A short-term government bond fund will invest in Treasury bills and/or Treasury notes with a 2-3 year maturity, as well as short-term obligations of federal government agencies.

There are many reasons why investors would add Treasury bonds to their portfolio, but these are just a few. U.S. Treasuries come maturities ranging from one month to 30 years. Shorter-term Treasuries are called Treasury bills (from one month to one year); intermediate term Treasuries are called Treasury notes (two year, three year, five year, seven year and ten year); longer term Treasuries are called Treasury bonds (30 years). Treasury bills are non-interest-bearing. Instead, they are bought at a discount to face value (par) and investors are paid the face value when the bills mature.

The risks of Treasury bonds are none unlike the risks of other bonds available to investors interested in adding these fixed income securities to their portfolio. Just like regular short term bonds, short-term government bonds are also highly sensitive to expectations for interest rates.

Bonds vs Stocks: Knowing the Difference

Obviously, investing in bonds is totally unlike investing in a more traditional asset, like stocks. There are many differences, but knowing some of the main differentiators will help you make sense of what mix you need in your portfolio.

Traditionally, stocks are used as a more risk on approach to investing as bonds are usually less volatile than stocks. The next time you look at your 401(k), you can probably find out the breakdown between the two.

According to Vanguard, one of the largest asset managers in the world, a portfolio that contains a 60/40 split, 60% stocks and 40% bonds, earned on average 8.8% compounded annual returns between 1926 and 2019.

Bonds tend to be more stable in the short term, where stocks tend to be more volatile. Where stocks tend to outperform over the long term, bonds underperform. However, both assets can earn money on your investment, simply by owning them. For bonds, investors make money through interest. As for stocks, the same applies except investors are paid dividends, or a share of the company's profits.

Each carries their own set of risks. Stocks may be much more liquid, meaning an investor can sell them just about any time, as long as the market is open. However, stocks are also very sensitive to any number of developments that can take place in the economy, as well as in a political sense. This is what makes them volatile compared to bonds.

However, while bonds may not be as volatile as stocks, they're also not as liquid as stocks, meaning selling them is a bit more difficult. This is the price you pay for stability.

There is no one size fits all approach when it comes to either investment. However, one rule of thumb when it comes to allocation to either side of the spectrum is the further away from retirement you are, the more you want to be invested in stocks. Thus, as you move closer toward goals like retirement, you should move more of your assets into bonds.

How Magnifi Can Help Find Bonds Investments

You can purchase government bonds directly from the US Treasury or you can invest in exchange traded funds (ETF) or mutual funds through your brokerage. Bond funds provide more diversification by holding bonds with different maturity dates, debt ratings and interest payments.

No matter how far you are from retirement, with your new investing co-pilot, Magnifi, you can find all the top bonds investments with a simple search. Check out some of the bond investments recommended below and let your search begin.

Try these searches other Magnifi users have used to get started on their bond investing journey:

References:

"Investing In Fixed Income Investments," May 30, 2023, magnifi.com, www.magnifi.com/learn/investing-in-fixed-income-investments
"Fixed Income Securities," Updated July 7, 2023, corporatefinanceinstitute.com, www.corporatefinanceinstitute.com/resources/fixed-income/fixed-income-securities/
"International Bonds," Updated June 28, 2023, corporatefinanceinstitute.com, www.corporatefinanceinstitute.com/resources/fixed-income/international-bonds/
"Municipal Bonds," investor.gov, www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products-0
“Interest Rate Risk Definition and Impact on Bond Prices,” investopedia.com, 25 September 2022, www.investopedia.com/terms/i/interestraterisk.asp
"What Is Quantitative Tightening (QT)?," Updated February 25, 2023, investopedia.com, www.investopedia.com/quantitative-tightening-6361478#:~:text=Quantitative%20tightening%20(QT)%2C%20also,of%20quantitative%20easing%20(QE).
"Bonds vs. Stocks: What's the Difference?," Updated Mar 14, 2023, fool.com, www.fool.com/investing/how-to-invest/bonds/bonds-vs-stocks/

Disclosures:

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The information and data are as of January 26, 2023 unless otherwise noted and subject to change. This blog is sponsored by Magnifi.

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