Are you looking to make some extra money without having to take on another job or pick up extra shifts? Investing in bonds is a great way to get additional semi-annual income. Bonds are also a dependable way to double your money for life’s significant expenses, like sending your child to college or reaching retirement.
Knowing where to start investing can be confusing and stressful. This guide will give you all the steps to get you started and tell you the essential information you need to know about investing in bonds.
How to Invest in Bonds
Investors tend to be drawn to the stock market for investing because of the earning power that stocks can bring. But investing in bonds is just as vital if you want to grow your wealth. Here are the steps to get you started investing in bonds:
- Understand what bonds are. Before you begin investing in bonds, you need to know what they are, how they work, what types there are, and the investment opportunities they provide.
- Choose the right investments for your financial goals. Decide what risk level you are comfortable with and what your most significant financial goals are. Use that information to compare investment types and decide what will help you best reach your goals. Are you saving for your child’s education? Do you want to save for a new car? These types of questions can help you determine what investment options best fit your needs.
- Decide if you need a financial advisor. If you are confident investing in bonds on your own, check out some online options that will allow you to do so without the added cost of advisor fees. If you read this guide and you feel like it has just chipped the tip of your investing iceberg, contact a financial advisor and ask for guidance.
What Are Bonds, and How Do They Work?
Bonds are loans made by an investor to a borrower with a predetermined interest rate and payout dates. It is like an IOU. The investor gives money to the borrower. The borrower then owes the investor that money back plus a specified interest amount.
Usually, when you invest in a bond, you are lending to the government, a municipality, or a corporation. Bonds typically pay interest twice a year on a specific date and are a dependable income for investors.
Bonds are issued at par value, which means at face value. The interest payments for bonds is known as its coupon. For example, a $5,000 bond with a 5% coupon rate will return a $250 coupon twice a year.
The value of bonds changes over time. There are options for both low-risk and high-risk bonds.
Investment Grade Bonds vs. Non-Investment Grade Bonds
Bonds are determined to be investment grade or non-investment grade based on their credit ratings. Investment-grade bonds are more likely to be paid on time and offer lower interest rates because they are less risky. On the other hand, non-investment grade bonds offer higher interest rates due to their high-risk nature.
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The Four Types of Bonds
Private and public corporations issue corporate bonds. Corporations issue bonds to raise money for things like purchasing new equipment, investing in research, paying shareholder dividends, and refinancing debt. The corporate bond market is the largest of all the bond markets. They are usually issued in multiples of $1,000 and $5,000.
High-yield bonds are bonds issued by corporations that do not qualify for investment-grade ratings. Moody’s Investor Services, a credit rating agency, determines if a corporation qualifies. The rating is based on the corporation’s ability to pay back its investors. These companies that have below investment grade ratings are required to pay a higher interest rate on their bonds.
Fixed-rate capital market bonds are bonds that provide steady semi-annual income to investors and consistent time frames for investing (usually 20-49 years).
Municipal bonds, also called “munis,” are issued by states, cities, counties, and municipalities. They are typically created to raise money for projects with a high financial cost, like building schools and highways. Because you are lending to the government, you could be exempt from taxes on these bonds. There are three general types:
- General obligation bonds: Municipal bonds that are backed by the government’s taxing power with full faith and credit.
- Revenue bonds: Municipal bonds that are not backed by the government’s taxing power.
- Conduit bonds: Municipal bonds that are issued by the government on behalf of private entities like hospitals.
The U.S. Department of Treasury issues treasury bonds on behalf of the Federal Government. At Treasury auctions, they are issued in amounts up to $5 million. In the bond market, they are issued for larger quantities. They are a safe investment because the U.S. government backs them with full faith and credit. There are three general types:
- Treasury bills: short-term market that can mature in as little as a few days to 52 weeks
- Notes: longer-term markets that mature within ten years
- Bonds: long-term markets that mature in 30 years and pay interest every six months
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Savings bonds are bonds issued by the federal government that have a fixed rate of interest. You can purchase them in paper form at banks or through payroll savings plans. You can also buy them in electronic form from the TreasuryDirect website. Lenders can only purchase up to $10,000 of each type of savings bonds per year. Interest on savings bonds is earned monthly and paid to the lender semiannually.
Types of Savings Bonds
The two types of savings bonds are Series I and Series EE They are low-risk bonds issued by the U.S. Treasury that offer several tax benefits. They are considered non-marketable, which means they cannot be sold on the secondary market. The interest rate for these bonds changes periodically and can be found on the Treasury site listed above. You can earn interest on them for up to 30 years. Typically, interest is reinvested for the life of the bond unless you cash it out. The earned interest is compounded semiannually and added to the principal of the bond. You will then earn interest on the interest.
Series I bonds can be purchased in paper form as part of your tax refund or in electronic form. For paper bonds, the minimum you can buy is $50, and the maximum is $5,000 per year. For electronic bonds, you must purchase at least $25, and the maximum is $10,000 per year. While you can buy electronic bonds in any denomination, from $25 to $10,000, you can only purchase paper bonds in increments of $50, $100, $200, $500, and $1,000. The combined interest is 1.90% from May 2019 to October 2019. The rate resets on May 1 and November 1 of each year. They earn both a fixed rate of return and an inflation rate, which is calculated twice per year.
Series EE bonds can only be purchased in electronic form. They require a minimum of $25 to invest, and you can buy them in any amount between $25 and $10,000. Most recently, the interest rate from May 21, 2019, to October 31, 2019, was 0.10%. Rates are reset each year at the beginning of May and November. The U.S. Treasury guarantees that EE bonds will reach their maturity within 20 years, or they will make up the difference. That means double your money!
Which is better, Series I or Series EE?
The Series I and Series EE bonds are very similar. The most notable difference is the variance in interest earned. First, the Series I bond earns two rates of interest, while the Series EE bond only earns one fixed interest rate. Also, the I bond pays a higher interest rate than the EE. However, the EE bond comes with a government guarantee that you will double your money in twenty years.
If you prefer the shorter twenty-year term with a government-backed guarantee, purchasing an EE bond is a good investment. If you are okay with a somewhat riskier investment that earns higher interest but is subject to market fluctuations, the I bond may be better for you.
Here is a chart comparison of the two:
|Benefit||Series I Bond||EE Bond|
|Current Interest Rate||1.9% (.5% is fixed-rate)||.10%|
|Minimum Purchase Amount||$50 electronic; $25 paper||$ 50|
|Flexibility in Purchase||Any denomination in electronic up to $10k; paper must be in specific increments||Any denomination up to $10k|
|Guaranteed at 20 Years||No||Yes|
|Interest Term||Up to 30 years||Up to 30 years|
|Earliest Withdraw||12 months after purchase||12 months after purchase|
|Withdrawal Penalty||3-month loss if redeemed before 5 years||3-month loss if redeemed before five years|
Taxes on Bonds
Most bonds that generate income are subject to the tax laws of the Federal Government and your state or local government if applicable. You will be expected to pay yearly taxes on interest earned for the year it is received. You can opt to defer taxes by holding them in a 401(k), IRA, or other retirement accounts with tax advantages. Taxes on capital gains or losses are also calculated for all bonds traded in the secondary market. There are tax exemptions for municipal bonds and savings bonds. Let’s take a look at each bond type and its tax expectations.
Interest earned from corporate bonds is taxable on the federal and state level. If you sell a corporate bond before its maturity date and receive capital gains, you will be taxed at your ordinary rate. Waiting at least one year after purchase will qualify your investment as long-term and could save you money. Capital gains on long-term investments are taxed at a maximum rate of 15%. If you lose money on your bond, you can offset your tax on earnings up to $3,000.
Interest earned on treasury bonds is exempt from state and local governments, but you will have to pay federal taxes on it.
Municipal “Muni” Bonds
Muni bonds are tax-exempt bonds. The interest you receive from municipal bonds is usually tax-exempt, as noted by the IRS, because they are used to finance government operations. The tradeoff is a lower interest rate than corporate bonds. For specific-purpose municipal bonds, interest earned from your investment is likely to be exempt from the alternative minimum tax and your state income tax.
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You are not required to pay state or local income taxes on Series I or Series EE savings bonds. You will, however, be responsible for federal taxes on both bond types. You do have the option of deferring the tax until maturity. However, keep in mind that doing this could cost you a chunk of your earnings at maturity because you will be paying all of it at once. Using your interest income for educational expenses will allow you to exclude it from your income, but you will have to meet several conditions. You must:
- Gave purchased the Series I bond after 1989.
- Pay the education expenses in the same year you cash in the bond.
- Have been 24 years or older on the first day of the month in which you purchased the bond.
- Meet the income limits required by the Treasury Department.
- For parents using the bond to pay for their child’s education, it must be in the parents’ name. The child can only be listed as a beneficiary, not as the owner.
- For married couples, you must file a joint tax return.
- The school must meet federal assistance standards like a guaranteed student loan program.
The tax benefit of the bond is reduced by the amount of any scholarship money or other tuition money paid toward the education expense. You must use both the principal and interest income from the bond to pay qualified education expenses. If the value of the bonds exceeds the educational costs, the amount you can exclude on your taxes is reduced proportionally.
Cashing Out Bonds Early
In most cases, there is no direct penalty from cashing out or selling your bond early. But that doesn’t mean you won’t lose money. Getting rid of your bond before its maturity date could cause loss of interest, loss of principal, transaction costs, and tax money.
You may incur transaction costs for the sale of your bonds. Although you own the bond, you will have to hire a broker to sell it. Broker-dealers, banks, and dealers make their money by selling bonds and other investments. To be compensated, they will charge a commission fee. There may also be additional fees for completing the sale. Be sure to ask your broker about all costs before committing to the purchase.
Similarly, you could lose principal on your bonds. Because market values fluctuate and the value of bonds changes, you could end up selling your bonds for less than your purchase price. Holding onto your bond until maturity will eliminate that issue.
When you cash in your bond, the buyer will pay you the accrued interest from your last payment date to the sale date. You will not earn any future interest because it will go to the new owner. Be sure to prepare for not receiving the semi-annual payment that you have been receiving.
You will have to pay taxes on capital gains from the sale of your bonds. If you buy a bond at par value and hold it until maturity, there is no capital gain. However, if you sell a bond before its maturity date, you will see either a capital gain or loss. Profits earned on bonds held less than a year are considered short-term, and anything over a year is deemed to be long-term. Short-term gains are taxed at regular tax rates, while long-term gains are taxed at a reduced rate of 15% to 20%.
Selling Savings Bonds
On the other hand, selling your savings bonds will cost you a penalty fee. EE bonds can Series I bonds can be cashed after one year, but if cashed out before five years, you will lose the last three months of earned interest. For example, if you cash out the bond after 24 months, you will receive only 21 months of interest. You will also lose the guarantee you receive on EE bonds if you sell before the twenty-year maturity date.
How does inflation affect bonds?
The U.S. Federal Reserve raises short-term interest rates to lessen the demand for credit when inflation rises. Usually, this also causes a rise in longer-term rates. The increase in inflation and short-term interest rates causes bond prices to fall, resulting in lower principal value.
The Benefits of Bonds
Bonds are a dependable way to ensure diversification of your portfolio, save for significant life events, make additional income, and pay less in taxes. They do not earn as much money as stocks, but they have the benefit of being less risky.
Having bonds in your portfolio helps stabilize it when your stocks are dropping with the stock market. Keeping a diversified portfolio will help keep your investment risk low and return higher dividends.
Bond investments are a great way to save for significant life expenses like retirement or education costs for your children or grandchildren. You don’t want to risk investing these types of savings in stocks. The EE bond would be a good option for this type of savings due to its guarantee.
With bonds, you will earn extra income without having to take any money out of your investment. Coupon payments are dispersed regularly and consistently.
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The Risks of Bonds
The two main risks when investing in bonds are the reduction of value and credit risk. The reduction of value is based on the fluctuation in interest rates, while the credit risk is based on the possibility of an issuer not making term payments as agreed.
Occasionally, the company that issued a bond can call it. When a company calls a bond, it is known as a call risk. When the issuer calls a bond, they redeem it and reissue it at a lower interest rate. A call forces the investor to reinvest it sooner than expected.
U.S. Treasury bonds are believed to be the lowest risk bond options because the Federal Government upholds them. Municipal bonds are a close second because government entities also back them.
On the other hand, corporate bonds are considered the riskiest bond option. But with high risk comes high-interest rates. An investor who owns 100 corporate bonds with a par value of 7% each will receive $7,000 of taxable interest annually.
How do you make money with bonds?
Bonds pay interest at maturity and also periodically based on market interest rates. Profits from market interest rates are paid in the form of a coupon. These profits are based on either fixed or floating interest rates. A fixed-rate is one that doesn’t change while a floating rate adjusts with the market. With a fixed-rate coupon, you will earn and receive that interest rate of the face value every year. You receive these payments, usually semiannually, as long as you hold the bond.
Bonds can also be bought and then sold for a higher price than what you paid. This method will earn you capital gains.
Zero-coupon bonds do not pay annually. They are sold at a discount to par rate but receive the par value at maturity. For example, you could purchase a $5,000 zero-coupon bond, and it returns $10,000 at maturity.
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Is investing in bond funds better than investing in individual bonds?
The disadvantage of bond funds is their cost. The management fees are higher than those for individual bonds and will reduce your overall return.
On average, bond expense ratios are about 0.6%. Bond index funds provide a low-cost option for investors who want broad market exposure.
The reason it’s risky is that bond funds have no guarantee that investors will be paid their principal back. With individual bonds, you are guaranteed your principal return plus your coupon rate when applicable. When the value of a fund falls, so does the value of the bonds. The outcome can be the forcing of investors to sell for less than they paid.
Individual bonds offer more flexibility and generate future cash flow. When you purchase a ten-year bond, you know exactly what you are getting in return and when you are getting it.
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What types of investments are there?
The four types of investments are stocks, bonds, mutual funds, and cash. For all four, the goal is to invest money for profit. Financial professionals recommend that you spread your investments across different asset classes to maximize your returns and balance your risk. Since this whole article is on bonds, we will spare you the details of the other investments in this section. Here is just a snapshot of the other three asset classes.
Stocks are riskier investments that earn or lose interest based on stock market values. As we have mentioned, riskier investments can return more substantial earnings because they have higher interest rates. But the higher risk also means more work. We recommend that you spend time studying stocks so that you can understand their performance.
Mutual funds are organized collections of bonds and stocks. A group of investors purchases these, pooling their money together, and trusting a professional to invest it based on their combined needs.
Cash investments include certificates of deposit, savings accounts, and money market accounts. They, too, are low risk and therefore offer less growth. Money market accounts are great options for short-term savings and emergency savings.
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How Bonds Can Help You Save for Retirement
Fidelity recommends that from age 25 to 67, you should save at least 15% of your pre-tax income for retirement. Based on national spending data, they further determined that retirees will need to generate about “45% of their retirement income from savings to maintain their lifestyle in retirement.” The most significant component of this equation is that you must start young for 15% to be enough. Many people do not start that young and have some major catching up to do later. Beginning a healthy retirement portfolio can help get you on the right track toward retirement.
Which bonds are best for a retirement portfolio?
The goal of a retirement portfolio is to earn as much as you can while you are working. That goal shifts once you retire, and it becomes about securing reliable income for the rest of your life. For long-term investments, it’s best to stay away from riskier options. The best combination is an assortment of different bonds. Good retirement bond options are treasury bonds, municipal bonds, and high-grade corporate bonds. U.S. Treasury bonds are the safest investment option in the world. There are four main ways to earn this type of return.
A total return retirement portfolio is made up of a mix of stocks and bonds. You should choose the options that you expect will give you the average return you desire. You can then determine how much you can withdraw while still growing your portfolio. These withdrawals are known as systematic withdrawals (40% total bonds with a mix of different terms and bonds).
Guarantee the Outcome: A guaranteed portfolio is made up of government bonds and annuity products. As the name suggests, you are guaranteed to earn the exact amount you expect. There is minimal risk, but you also will not gain from inflation. Because you are also shifting the risk, you will pay more capital. This approach could leave you locked in even if a life-changing event occurs.
This is a risky portfolio option made up of income-producing investments. Because you are counting on high-yield investments, it could result in a loss of principal. That makes it a less dependable long-term goal. If you are comfortable with an inconsistent income, this could be an option for you.
This is a portfolio built in segments based on the point in time you will need returns on each investment. This approach is the ladder approach. You create the first rung of the ladder with safe investments like municipal bonds and certificates of deposit, and you use the income from these for spending habits. The goal is similar to that of pension plans. Its purpose is to make sure you back your retirement expenses with cash flow from fixed sources for the next five to ten years. You then add investments with goals to smooth your transition into retirement. You leave space in your portfolio for investments that aim to grow and earn more significant returns. Then, you manage your portfolio and add to it to harvest the growth and to reach your target for retirement.
How much of your portfolio should be in bonds?
The portion of your portfolio that should be in bonds depends on your age and investment goals. To find the right ingredients to build your financial pie, you need to know your risk tolerance and decide how much you would like to earn in what time frame. But any well-rounded portfolio should contain bonds.
For retirement-aged investors, you will want to consider the options listed above to ensure you can continue to withdraw from your portfolio while still growing it.
If you are a younger investor, you may want to consider a higher-risk asset allocation that consists of a more substantial amount of stocks. The riskier investments will earn you a higher return on your investment. For example, a 40-year-old investor may want to divide their portfolio into 30% bonds and cash investments and 70% stocks. Younger investors may also want to be more daring with their bond investments.
For an investor who seeks moderate growth and likes a little less risk, a makeup of 60% stock and 40% bonds and cash investments would be ideal. Your portfolio may go down as much as 20% in value in any given calendar quarter or year.
Lastly, for the conservative investor, you should have at least a 50/50 split with stocks filling no more than half of your portfolio and stocks and cash investments dividing the other half.
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How do I buy bonds?
The easiest way to buy bonds is through a broker. Just remember that a portion of your earnings will go to the broker as payment for their help and advice.
Buying savings bonds from the U.S. Treasury is an easy way to get started on your own. You can save yourself a fee by going to a bank or the TreasuryDirect website to get started.
Even though you should now have a better understanding of what bonds are, you may still feel like you need some practice and expert advice. I recommend that you follow one step at a time and continue researching as much as you can. If your financial situation and goals are complicated, consider meeting with a financial advisor who can help get you started.
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How do I find a broker to get started?
Here are a few tips for finding a broker:
- Find a broker that specializes in bonds. Meet with the broker and make sure you are comfortable with them. Read customer reviews and ask for credentials.
- Know the costs associated with the broker. If you cannot find the costs associated, ask what they are down to the penny. Ask how much broker fees are and how to pay them for each transaction. Ask about commissions, mark-ups, and mark-downs.
- Ask questions about the bond. Learn the liquidity of the bond by asking when the bond last traded and at what price it traded.
Bonus Bond Tip
Top Corporate Bonds in 2019
U.S. News recommended buying these seven corporate bonds in 2019:
- GameStop (GME)
- Allegiant Travel Co. (ALGT)
- iShares Floating Rate Bond Electronic-Traded Fund ETF (FLOT)
- Icahn Enterprises LP Common Stock (IEP)
- HCA Healthcare (HCA)
- iShares iBonds Dec 2019 Term Corporate ETF (IBDK)
- Western Union (WU)
Do you have any experience with investing in bonds? If so, we’d love to hear your tips!