In the world of investing, bonds may not be the most glamorous asset when compared to a blue-chip stock or tech sector-tracking exchange-traded fund (ETF). But understanding how to invest in bonds —and more importantly, why you should consider adding them to your portfolio — is important for any investor, whether you’re looking to balance out higher-risk securities or build a fixed income portfolio.
In the simplest terms, bonds are like an IOU. When you buy a bond, you are essentially lending money to a borrower (the government or a corporation), with the expectation that you’ll receive that money back after a certain amount of time, plus interest (which in bond terms is called coupon). Bond investing is not risk free, but is usually considered a more conservative strategy than investing in stocks.
Several types of bonds are available. If you want to add diversification to your portfolio with bonds, here’s a brief overview of the more commonly traded ones in the U.S. market. These include debt securities issued by the U.S. Treasury, municipal bonds, corporate bonds and other government bonds.
U.S. Treasury Debt Securities
The U.S. Treasury issues debt securities (bonds) in order to finance various federal government endeavors. Many different varieties of Treasury bonds exist, and the three main types are classified by the time frame on the loan: Treasury bills (T-Bills), Treasury notes (T-Notes) and Treasury bonds (T-Bonds).
T-Bills are considered by some to be among the least risky investments available. They mature in one year or less and are known as zero-coupon bonds since they don’t pay interest before maturity. Instead, they are issued in the primary market (we’ll explain primary and secondary markets below) at a discount and then pay their full face value at maturity.
T-Notes mature in two to 10 years and pay a coupon every six months. T-Bonds mature in 20 to 30 years, and like T-Notes pay a coupon every six months.
Interest received from U.S. Treasury debt securities is taxable at the federal level, but not at the state level. However, if you purchase a Treasury debt security in the secondary market at a deeper discount than you’d receive if buying at auction, and then you resell it at a profit or receive full face value at maturity, those gains are taxable at both the federal and state level. These things can get tricky, so consult your tax professional for more information.
How T-Bills earn a return at maturity.
Here’s a quick example:
You buy a 30-day T-Bill for $998 on May 1
On June 1, the T-Bill matures, and you receive $1,000
Your yield is $2 over 30 days, or 0.1%
(That means your annual yield would be 1.2%, with $2 every month for 12 months.)
Note the price of a T-Bill is quoted in units of $10, so a bill purchased for $998 would be quoted as $99.80. Simply multiply the quote by 10 to get the total amount you’ll pay per T-Bill.
Municipal bonds (also known as munis) are issued by states, cities, counties, and other municipalities. Money generated from the sale of municipal bonds is typically used to fund public improvements like highways, bridges, schools, hospitals, sewer systems, and other projects.
You’ll see two varieties of municipal bonds: General obligation bonds (GO for short) and revenue bonds.
General obligation bonds are backed by the issuer’s ability to collect taxes — the state, for instance. Revenue bonds are issued by entities like water companies or sewage treatment plants that generate revenue over time, and then use this income to make interest payments and repay the loan in its entirety on the maturity date. A double-barreled credit is a municipal bond that blends these two types.
Typically, municipal bonds pay periodic interest every six months, or twice per year until the bond matures.
Many municipal bonds are tax-exempt at the federal level. They are usually also tax-exempt at the state and local level if the investor resides in the same geographic area where the bond is issued — which is why that scenario is often called triple tax-exempt. Tax-exempt munis generally pay a lower coupon than taxable bonds. So when comparing yields of tax-exempt bonds with taxable bonds, make sure you do so on an after-tax basis.
Like government entities that issue bonds to raise money for large public projects, corporations issue bonds to fund expensive business ventures.
Corporate bonds (corporates for short) might be used to expand a business, build a new factory, or obtain new equipment, for example. This type of bond tends to have a higher risk of default than government or municipal bonds, and as a result they generally pay higher yields. But some corporates involve more risk than others and could be more likely to default, so don’t be tempted by a high coupon alone. Interest on corporate bonds is taxable at both the federal and state level.
Although they may accompany nearly any type of bond, corporate bonds are often riddled with fine-print clauses that require your close consideration before investing. In addition to somewhat common clauses like call and put features, corporate bonds may have equity components, floating coupons or other unique features. This list is by no means exhaustive — so don’t skim over the fine print.
Convertible bonds are a type of security that combines a debt investment (bonds) with an equity component (stocks). As an investor in convertible bonds, you receive coupon payments and expect face value at maturity, just like the average bondholder. In addition, convertibles give you the right to exchange your corporate bond for a predetermined number of the issuer’s shares of common stock at a predetermined price. Typically, this conversion occurs after the issuer’s common stock has risen to a price that makes converting the bond more beneficial to you, the bondholder. Prices for convertible corporate bonds tend to be more volatile than their nonconvertible cousins, since the value of these bonds is more closely tied to the stock’s activity.
Corporate bonds sold with equity warrants attached may be even more enticing to invest in. That’s because warrants provide you the right to buy the issuer’s common shares at an attractive price at some point in the future.
Floating-rate notes or bonds (AKA floaters) also pay periodic interest and return face value upon maturity. However, the coupon rate adjusts higher or lower over time. The rate of interest is reset periodically, based on a benchmark such as short term Treasurys or LIBOR (London Interbank Offered Rate).
Other Government Bonds
A number of private entities that are backed by the U.S government issue bonds as well. These are called government-sponsored enterprise bonds and government agency bonds (yes, both are a mouthful).
These bonds are issued by entities like the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Company (Freddie Mac), the Federal Home Loan Bank, the Federal Farm Credit Bank, and the Student Loan Association (Sallie Mae).
Typically, these bonds are tax-exempt at the state and local level but are subject to federal tax. Check with your tax adviser for the specific implications of these bonds.
How the bond market works.
Like stocks, there are two main avenues through which bonds are sold: the primary and secondary markets. There’s the primary market, which is where the issuer sells new bonds to the public for the first time. And then there’s the secondary market, where investors buy or sell bonds from other investors with no involvement from the issuing firm.
The primary market for bonds is similar to the primary market for stocks where initial public offerings (IPOs) occur. Investors buy bonds from an underwriter, with the underwriter acting as the middleman between the issuer and the public. The underwriter then collects the money from bond sales and gives it to the issuer, after taking a commission, or underwriting fee.
The investor’s price per bond is usually equal to the face value, plus any transaction costs, like commissions from your broker. (Exceptions to this rule include zero-coupon bonds, which are sold at a deep discount to face value.)
Keep in mind: When you buy a bond, you don’t have to wait until it reaches its maturity date. As with other forms of securities, you can typically buy and sell them at any point. However, the mechanism for trading bonds is quite different than other securities. That’s where the secondary bond market comes into play.
On the secondary bond market, bonds are bought and sold throughout the day by individual investors and institutions. When you buy a bond in the secondary market, you purchase it from another investor (likely a large institution) instead of the original issuer.
In some ways, buying or selling bonds in the secondary market is similar to the trading of stock shares after an initial public offering (IPO). Since market conditions fluctuate, so do the prices of bonds.
In the case of equities, nearly all of the transactions in a particular stock are centralized —meaning buyers and sellers come together to do business in one place. That could be either in person or through agents as with the New York Stock Exchange (NYSE), or through virtually centralized electronic marketplaces, like the NASDAQ. Although some bonds are listed on the NYSE and trade in the fashion just described, this is only true for a small number of bond issues.
The secondary market for nearly all bond issues is handled through a decentralized network of independent dealers, generally organized by type of security. The bond market is an over-the-counter market (OTC), as opposed to an exchange, or even a group of exchanges. Although you can sell your bond investments before maturity, it’s not as easy as it is to sell stock holdings. What’s more, it’s possible to incur a capital loss if selling a bond before maturity.
Think of it this way: Thousands of stock issues trade nearly continuously during regular market hours. The bond market has millions of bond issues, with many rarely trading, which explains why many bond issues are illiquid.
Understanding bond prices in the over-the-counter market.
Bond prices are expressed as a percentage of the face value, and, much of the time, a bond’s face value will be $1,000. So, if a $1,000 bond is trading in the secondary market at a price of $98.475, you’ll pay $984.75, or 98.475% of the bond’s face value.
Because bonds primarily trade OTC, pricing is not as straightforward as it is in the stock market. In the equities market, it’s possible to know the stock price of a specific company, for example, at any given time by obtaining a stock quote. No matter where you are, or with which broker you have an account, everyone pays the same price for the stock at a specific time (the only variation may be the commission you’re charged). Things work much differently with bonds.
To get a quote on a corporation’s 10-year bond maturing on June 29, 2020, you or your broker would need to call several dealers. Not every dealer has access to every bond. And from the dealers that can provide a quote, it’s possible all of them may be different. Why is that?
A bond dealer’s quote stems from the quantity of that dealer’s inventory, the cost incurred when accumulating that inventory, how many bonds are to be traded, and how much profit is desired when selling the inventory (termed markup). A dealer’s cost and markup are not public knowledge. To add to this, many bonds trade infrequently, which makes obtaining a quote more difficult.
Several factors can impact the price of a bond in the secondary market, including:
- the bond’s coupon (interest paid) compared to current and expected future interest rates
- credit rating of the issuer
- economic conditions, including inflation and stock market performance
- liquidity of a particular bond
Interest Rate Environment and the Coupon
The most important factor that influences a bond’s price is its coupon rate compared to current or expected future interest rates. A bond’s coupon may be favorable or unfavorable compared to the interest you could receive on other investments.
Bond prices have an inverse relationship to prevailing interest rates in the economy. In other words, as prevailing interest rates go down, a bond’s price in the secondary market will usually go up. As prevailing interest rates go up, typically a bond’s price will go down. Call this the see-saw, or inverse, relationship between bond prices and interest rates.
Here’s an example: If a bond pays a 6% coupon and the prevailing interest rate drops below 6%, that bond pays comparatively better than the alternatives. So, it will increase in value and will usually trade higher than its face value — that’s known as a premium. If the prevailing interest rate rises above 6%, the bond will pay comparatively worse than the alternatives, so its value will decrease and it will usually trade lower than its face value, or at a discount.
Just as individuals receive credit ratings based on their past borrowing habits and ability to pay off debt, bonds and their issuers are rated by independent companies based on the likelihood that issuers will be able to meet their obligations — that is, to pay the coupon over time and return the principal at maturity.
Of the main bond types, corporate bonds generally present the most risk, followed by municipal bonds. Treasury bonds, on the other hand, are considered a virtually risk-free investment. In fact, investors consider them so low risk that all other bonds are rated with Treasurys as a benchmark.
Bond ratings are based on the issuer’s financial stability, and they’re the key indicator of how much risk is assumed when buying a particular bond. Bonds issued by entities with a high probability of meeting obligations are known as investment grade. Since they entail relatively low risk, they generally pay a lower coupon. Riskier bonds are referred to as high-yield or junk bonds, and usually pay a higher coupon.
Three main companies issue bond ratings: Moody’s, Standard & Poor’s, and Fitch. The ratings they use are listed in the table below. The first column describes whether the bond is considered investment grade or junk. The final three columns are the specific ratings assigned by the evaluating companies.
|Investment||Aa1, Aa2, Aa3||AA+, AA, AA-||AA+, AA, AA-|
|Investment||A1, A2, A3||A+, A, A-||A+, A, A-|
|Investment||Baa1, Baa2, Baa3||BBB+, BBB, BBB-||BBB+, BBB, BBB-|
|Junk||Ba1, Ba2, Ba3||BB+, BB, BB-||BB+, BB, BB-|
|Junk||B1, B2, B3||B+, B, B-||B+, B, B-|
|Junk||Caa1, Caa2, Caa3||CCC+, CCC, CCC-||CCC|
|Junk||C||D||DDD, DD, D|
So how do ratings affect bond prices over time?
It’s important to understand that a bond’s rating is not static. If the issuer’s financial stability improves over the life of the bond, then the rating will be updated accordingly, and the value of the bond will generally increase. If the issuer’s stability deteriorates, then the rating will go down and the value of the bond will generally decrease.
Pro tip: Whenever you buy a bond, it’s important to stay informed about its rating throughout the life of your investment.
In general, the lower the bond rating, the higher the interest paid. But beware. Don’t get lured in by the potential of earning high interest if the bond has a lousy rating.
Inflation plays an important role in bond values. Like interest rates, inflation is inversely proportional to bond prices. Because higher inflation deteriorates the real value of a bond’s coupon, the coupon becomes comparatively worth less. So the higher inflation goes, the more the price of a bond decreases. If inflation gets too high, the concern is it will outpace the rate of interest received from the bond investment. To combat high inflation, bond investors might turn to other investments that carry more risk such as stocks, since equities may provide the opportunity for higher returns.
The price of bonds may also be affected by other conditions in the overall marketplace. For example, if the stock market is performing poorly, more people may be more interested in bond investing, and prices in the bond market will tend to rise. If the stock market is performing very well, people may be less inclined to invest in a relatively low-yield investment vehicle like bonds, so prices will tend to fall.
How to compare bonds.
When researching potential bond investments, it’s difficult to compare bonds with different prices, coupons and maturity dates. The first thing most investors look at is the yield. Simply put, the yield is the percentage of the bond’s price you’ll receive over time. (This is different from the bond’s coupon rate.)
If you want to have an idea of what yields will look like in the future, you may want to consult a yield curve, which you can find on the U.S. Treasury’s website. Yield curves are graphs that offer indications of economic changes, inflation, and interest rates and may be used as a tool to inform your fixed income bond investing strategy.
Let’s break down yield further. Say you’ve bought a bond at par (face value of $1,000) with a 6% coupon. Since 6% of $1,000 is 60, you’ll receive $60 a year in interest. Here, the coupon and yield are equal.
But what if you bought the bond in the secondary market for $800? In this case, yield and the coupon are different. To determine the bond’s current yield, simply divide the annual interest payment by your cost basis. In this situation: $60 interest per year divided by $800 cost basis = 0.075, so your current yield is 7.5%.
Conversely, if you bought the same bond at a premium of $1,200, your current yield will be lower than the specified coupon rate.
$60 interest per year divided by $1,200 cost basis = 0.05, so your current yield is 5%.
Know that the above scenario is an oversimplified description of a bond’s yield. In fact, there are four additional variations on yield that you need to know about: yield to maturity (more on this momentarily), yield to call, yield to put, and yield to worst. You should also understand how to compare yields on tax-exempt bonds versus taxable bonds.
Yield to Maturity
While yield provides you some basic information, yield to maturity (or YTM) is the total return that’s anticipated if you hold the bond until it matures. A bond’s YTM is a complex calculation that can only be determined with a bond calculator. It takes into account the actual price paid for the bond (not the face value) along with the coupon payments received over time, among other factors.
When investors talk about yield, most of the time they’re referring to YTM. This figure makes some basic assumptions, but these assumptions may not pan out. The point of this number is not to estimate how your bond investment will perform. Instead, it allows you to make an apples-to-apples comparison to other bonds when selecting a fixed income investment.
Yield to Call
Some bonds grant the issuer the right, but not the obligation, to buy back or call the bond at a specific time before the maturity date. Yield to call makes the assumption that the issuer will exercise the right to buy the bond back early. It’s calculated much the same way as YTM, but since there will be less time to receive interest payments, generally yield to call will reflect a lower return to the investor. However, a bond’s call price will oftentimes slightly exceed its face value. This additional amount may offset at least some of the foregone coupon payments once the bond has been called.
Yield to Put
Yield to put is similar to yield to call, except in this case it’s the investor who has the right to sell the bond back early. Again, when calculating this number, the assumption is made that this right will be exercised.
Yield to Worst
When bonds are callable, puttable, or have other similar features, it’s a good idea to examine the yield to worst. This is the worst-case yield figure, so it would be the lowest possible yield out of yield to maturity, yield to call, or yield to put.
How to calculate an equivalent yield.
Fully taxable corporate bonds usually generate higher interest payments than fully tax-exempt municipal bonds. But that doesn’t automatically mean these higher-coupon bonds are a sweeter deal when all’s said and done. Assuming all other factors are equal, you need to examine the yields of these bonds under equal tax conditions to make a fair comparison.
Depending on the information you have available at the time, this will involve one of two formulas: calculating the after-tax yield of a taxable corporate bond or calculating a taxable yield for a tax-exempt muni bond. To determine the after-tax yield of a taxable bond, here’s the formula:
Pretax yield x (1 – tax rate) = equivalent after-tax yield
Let’s put this equation into practice. Imagine you’re in the 30% federal tax bracket and you have the option of choosing between a taxable corporate bond with a yield of 4% or a tax-exempt muni bond with a yield of 3%. The after-tax yield for the taxable corporate bond is calculated as follows:
4% x (1 – 30%) = 0.04 x 0.70 = 0.028 = 2.8% after-tax yield
As you can see, for someone in the 30% tax bracket, the yield of 3% from the tax-exempt muni bond would be greater than the corporate’s after-tax yield of 2.8%. Although at first glance, the taxable corporate bond had a higher yield, that’s not the case after you do the math. Let’s look at this from the other point of view and calculate the taxable yield for a tax-exempt muni bond:
Tax-exempt return divided by (1 – tax rate) = equivalent taxable yield
Still using the 30% federal tax bracket, you’re considering a tax-exempt muni bond with a yield of 5%.
5% divided by (1 – 30%) = 0.05 / 0.70 = 0.071 = 7.1% equivalent taxable yield
In this scenario, you’d need to find a corporate bond yield of 7.1% to deliver the same results as a fully tax-exempt muni bond yielding 5%. Sometimes the math can get even more complicated if you compare a corporate bond with a muni bond that’s only partially tax-exempt. Bottom line: When in doubt, consult your tax adviser.
Laddering Your Bonds
When you choose to add bonds to your investment portfolio, your first big decision is what percentage of your assets to allocate to bonds versus stocks. This balance will be based on factors like your risk tolerance and your investment time horizon — and the ratio will likely shift over time.
Once you’ve determined what percentage of your portfolio will be devoted to bonds, the next step is to decide which fixed income strategies work best for you. For starters, you’ll likely consider buying Treasurys, municipal bonds, corporate bonds, preferred stock, an income fund, or a money market fund.
Then consider whether you want to select a blend of bonds that spread your risk over a series of different maturities — while still maintaining an average maturity that suits your investment goal’s time horizon. One strategy that can help you achieve that? A bond ladder, or a series of bonds with a range of maturities.
Here’s how it works. Say you bought equal amounts of Treasurys due to mature in one, three, five, seven and nine years respectively. Your portfolio would have an average maturity of five years (1+3+5+7+9 / 5 = 5). When the first batch matures the following year, you’d build the next rung of the ladder by putting the money into new ten-year notes. Your portfolio would then have an average maturity of six years. Two years after that, when the three-year notes matured, you would buy more ten-year notes, and continue to do so whenever a note matures until you’ve reached your financial goal. Bottom line: Laddering keeps this batch of Treasurys’ average maturity in the five- to six-year range.
Laddering and coupon reinvestment go hand in hand. As each bond investment makes its periodic coupon payments, you can save those payments in a bank account. Then, when you’re ready to add the next rung in your ladder, you may want to apply those saved coupon payments to your next bond investment.
One benefit of laddering is that you don’t need to worry as much about fluctuating interest rates. If rates do rise shortly after you bought this year’s bonds, soon enough you’ll have money available to reinvest at the higher rate. Similarly, if rates decline after you buy, at least you’ve locked in the higher rates for one portion of your portfolio.
How to build a bond ladder.
How many rungs should your ladder have? That depends on your investment goals and time horizon. If you’re looking at a 10- to 15-year horizon, you might ladder in two-year increments. If your horizon is shorter (say, two to three years), you might lean toward rungs every three months. If your timeframe is even shorter than that, it may not make sense to ladder at all. That’s because laddering does increase your commission costs —but the trade-off may be worth it for balancing risk with longer-term goals.
Building a ladder with Treasurys is relatively simple, since these bonds are highly liquid and available in increments of $1,000. Treasurys are available with maturities as short as a few days and up to 30 years.
A handy alternative to laddering, particularly if your investment capital is limited, is simply investing in a low-fee bond fund. Money managers typically stagger bonds within their funds so that different maturities come due at different times.
Bonds may not be flashy, but there’s a lot more to them than meets the eye. No matter how you invest in bonds, whether it’s through the purchase of individual bonds or by investing in bond mutual funds or ETFs, these securities are often seen as a staple in an investment portfolio. If you’re looking to add balance to an existing stock portfolio, or build a fixed income portfolio with more conservative investments, bonds can be a smart security to invest in.