A successful long-term investment strategy strikes the right balance between safety and risk.
When you’re seeking more safety, whether by collecting steady income or using an asset that acts as a counterweight to a volatile stock market, it might be time to buy bonds. But bonds don’t trade on a central exchange like stocks do, so navigating the landscape can be tricky. Here’s how to get started.
What is a bond?
A bond is a loan an investor gives to a corporation or government so it can fund a public works project, invest in new lines of business, or refinance its existing debt, among other things.
In return, the borrower pays interest—known as a coupon payment—on a regular schedule, often semiannually or quarterly. At the bond’s maturity date, investors get back what they loaned plus any unpaid interest. This is why bonds are often referred to as fixed-income securities: Investors know what they’re getting.
“Both bond funds and individual bonds can provide an additional stream of income in a portfolio, with less risk than individual stocks or stock mutual funds,” says David Rosenstrock, certified financial planner and founder of Wharton Wealth Planning.
“Generally, those who are younger are advised to invest more aggressively, tapering to more secure investments, such as bonds, as they grow older,” Rosenstrock says. “As you near retirement and once you retire, you’ll have to rely on your accumulated assets for income.”
There are three main types of bonds you can invest in:
- Municipal bonds: Munis are debt securities issued by local, city, and state governments and usually categorized as general obligation (GO) bonds or revenue bonds. GO bonds are high-quality bonds that promise to repay bondholders, even if that means increasing local taxes. Revenue bonds are repaid using the revenue from a specific project. Muni bond interest payments are generally free from taxation at both the federal and state levels.
- Government bonds: These are issued by the U.S. Treasury Department and are backed by the full faith and credit of the federal government. This means they carry zero credit risk, but as a result will often pay less interest than a non-government bond. You have to pay federal taxes on the interest you collect, but it’s usually exempt from state and local taxes.
- Corporate bonds: When a private or public company needs to invest in research and development, fund an acquisition, pay shareholder dividends, refinance debt, or buy new equipment, it can issue bonds. Default risk, or the probability that the borrower (the company) fails to repay its loan on time, is one of the biggest considerations for investors. Proceeds from corporate bonds are generally taxed at both the federal and state levels.
Bonds are further categorized by how long an investor collects interest before getting their principal investment back. They can be short-term, with a maturity date between one and five years; intermediate, with a maturity date between five and 10 years; or long-term, with a maturity date between 10 and 30 years. However, some bonds can be redeemed sooner than the maturity date if they have a “call” feature.
How to buy bonds
The steps to buying bonds will look different depending on how you plan to include them in your investment plan.
“Broadly, you should figure out when you will need money—that’s a useful way to determine if a specific bond is right for your portfolio,” says Frank Newman, a portfolio manager at Ally Financial. He adds that your tax situation and risk tolerance are important factors to weigh, too.
An easy way to understand bond investing is to look at the two primary purchase methods—one for buying government bonds and another for buying muni bonds, corporate bonds, and bond funds.
1. Use TreasuryDirect
The most straightforward way to buy individual government bonds—often simply called Treasurys—is through TreasuryDirect.gov. These include Treasury bonds, TIPS, Treasury notes, Treasury bills, and savings bonds. All have zero credit risk, meaning you’re guaranteed to recoup your initial investment if you hold the bond until its maturity date, though you can sell it earlier.
Treasurys are sold during “auctions” on specific dates throughout the year, which you need an account on TreasuryDirect.gov to access. You’ll typically see the bond in your account within a few days of buying it at auction, and you have to hold it for at least 45 days before selling it.
If you’re interested in buying a Treasury bond fund (i.e. a basket of multiple T-bills, notes, or bonds) you’ll need to do so through an investment company.
2. Use a brokerage account
To buy muni bonds, corporate bonds, or Treasury bond funds, you usually need to work with a broker. You can do that by opening an investment account online—either a taxable brokerage account or a tax-advantaged retirement account, depending on your objectives for the money you’re investing—and checking out what’s offered.
“Just as you can invest in individual stocks or ETFs when investing in the stock market, you have a choice between individual bonds and bond funds when investing in bonds,” Rosenstrock says. There are costs and benefits to both.
Buying individual bonds may require more time and effort, and sometimes a larger initial investment (most bonds are issued in $1,000 increments) plus a commission fee, but you’ll have the ability to choose exactly the bonds you need to match your investment objective.
“For example, if a bond matures in five years, and you and your spouse are saving for a down payment on a home five years from now, that asset-liability time matching can work,” Newman says. You’ll also need to check the bond’s coupon payment if you’re looking for cash flow, and importantly, its credit rating. Investment-grade bonds—those with the lowest risk of default—are rated BBB or higher by Standard & Poor and Fitch and Baa3 or higher by Moody’s.
“Unlike stocks, bonds are very heterogeneous, and for every issuer, there are sometimes many securities to choose from, with different coupon rates, maturities, and technical nuances,” says Reid Hartman, cofounder and head of quantitative economics at Global Predictions, an investing forecaster and portfolio management tool. For those reasons, buying shares of a bond fund could be a better fit.
“Most individual investors simply just don’t have the time or the means to buy individual bonds,” Hartman says. “For most people, buying a bond ETF is far simpler, and gets them the broad exposure they want within their portfolio without being concentrated in any one specific bond or type of bond.”
Since funds hold various types of bonds, they don’t have one fixed maturity date, so returns are less certain. But you do have the opportunity to automatically reinvest interest payments, also known as fund dividends, to propel compound growth.
If you’re comparing bond funds to buy, the total return is a good metric to look at because it includes reinvested interest income in addition to the price gains or losses generated by every bond in the fund (though returns can fluctuate over time based on a host of factors, especially interest rates). Since bond funds require some active professional management, you’ll also have to pay an ongoing fee, known as an expense ratio. Take note of whether the total return accounts for this fee.
Individual bonds are less liquid assets than stocks, so they tend to require more careful consideration before buying. Getting started is as simple as opening an investment account through a bank or online broker, or going to TreasuryDirect.gov to buy government bonds.
The type of bond you should buy depends on your own risk tolerance, investment goals, and time horizon, as well as the issuing corporation or government’s credit rating and the bond’s yield and maturity date.
If you’re looking for the simplest way to get bonds into your portfolio, buy shares of a bond mutual fund or ETF that matches your investment objective, rather than researching and choosing individual bonds.
EDITORIAL DISCLOSURE: The advice, opinions, or rankings contained in this article are solely those of the Fortune Recommends™ editorial team. This content has not been reviewed or endorsed by any of our affiliate partners or other third parties.