Bonds don't make for catchy headlines the way stocks often do, but they're typically considered a safer addition to a well-rounded investment portfolio. Whether you're attempting to balance risk, generate income or diversify your holdings, bonds are important for investors to understand.
Learn more: You can choose to invest in bonds through an Ally Invest Self-Directed Trading account
What are bonds?
Think of a bond as an "I.O.U." When you buy a bond, you're essentially lending money to a borrower — which could be a government, a municipality or a corporation. In return, the borrower promises to pay you back the original amount, known as the face value or principal, on a specific date (i.e. the maturity date). The borrower will also pay you regular interest payments along the way (a little like dividends).
Think of a bond as an "I.O.U." When you buy a bond, you're essentially lending money to a borrower. In return, the borrower promises to pay you back the original amount.
Key features of bonds
Issuer: The entity that issues the bond and borrows the money (e.g., the U.S. Treasury, a city or a company)
Maturity date: The date when the bond issuer repays the face value, or principal, to the bondholder
Coupon rate: The fixed interest rate the bond pays (calculated based on the bond’s face value)
Bond yields: The actual return an investor receives on a bond (calculated based on the bond’s current market rate)
Example of coupon rate vs. bond yield
Say there’s a $1,000 bond with a 5% coupon rate (i.e., $50). If an investor purchases the bond at a $1,000 market price, then the bond yield is still 5% — same as the coupon rate.
However, let’s say the investor purchases the bond for $800. That puts the bond yield at 6.25%, because the $50 makes up a greater percentage of the current market price of $800.
This is an important factor to look at as you assess the value of any bond you're considering.
Read more: Using tools when investing on your own with Ally Invest. Here’s how
Types of bonds
The bond market has many different types of bonds, each with its own special features.
Government bonds
These are generally considered among the safest bonds due to the backing of a government entity.
Treasury bonds: Issued by the U.S. federal government (e.g., Treasury Bills, Notes and Bonds)
Municipal bonds: Issued by state and local governments to fund public projects
Agency bonds: Issued by government-sponsored enterprises like Fannie Mae or Freddie Mac
Corporate bonds
Companies issue corporate bonds to finance their operations or growth. They usually offer higher yields than government bonds, but they also have more risk.
Other types of bonds
Mortgage-backed securities (MBS): Bonds backed by a pool of mortgages
Treasury Inflation-Protected Securities (TIPS): U.S. Treasury bonds designed to help protect investors from inflation
High-yield corporate bonds: Also known as "junk bonds," these are issued by companies with lower credit ratings and offer higher yields to attract investors
International and emerging market bonds: Issued by foreign governments or corporations, offering global diversification but often with additional risks
Benefits of bond investing
Bonds play a crucial role in many investment portfolios for several reasons:
Income stability: Bonds provide predictable, regular interest payments, offering a steady stream of income.
Portfolio diversification: Bonds can help diversify a portfolio. Securities behave differently as the market moves, so diversification can help a portfolio weather a changing market
Risk mitigation: Bonds are generally considered less volatile than stocks, and therefore, a more conservative investment choice
Understanding bond risks
While often considered safer, bonds aren't without risk. It's important to be aware of:
Interest rate risk: As interest rates rise, the value of existing bonds with lower coupon rates typically falls
Credit risk: The risk that the bond issuer may default on its interest payments or fail to repay the principal
Inflation risk: Inflation can erode the purchasing power of a bond's fixed interest payments over time
Liquidity risk: Some bonds may be difficult to sell quickly without affecting their price, especially in less active markets
How to invest in bonds
Investing in bonds can be a straightforward process, especially with the right tools and guidance. For beginners, there are two main ways to invest:
Individual bonds: These are single bonds offered by specific issuers and aren't generally purchased through a brokerage
Bond funds or bond exchange-traded funds (ETFs): Bond funds and ETFs are essentially collections of securities. These are often attractive to investors because they offer diversification and are often a simpler and less pricey entry point to bond investing
3 steps to invest in bond funds or exchange-traded funds (ETFs) through Ally Invest
If you’re not already an Ally Invest Self-Directed Trading account holder, you would first need to open and fund an account. Otherwise, log in and navigate to your account dashboard.
Use the in-account tools to research any bond funds or ETFs that interest you. You can search for these using their ticker symbols, much like stocks.
If you choose to buy, you can search and purchase bond funds or ETFs as you would a stock, using the available funds in your account.
Regardless of the method, all bond fund investing through Ally Invest is accessed via the secondary market. This means you can buy bond funds that have already been issued and are being traded between investors, rather than directly from the original issuer. When you buy bond funds or ETFs through this method, you get the flexibility to compare a vast selection of bonds and choose which ones fit your specific goals.
Investment strategies
Diversification: This refers to spreading your investments across different types of bonds, issuers and/or maturities to reduce risk. This can be achieved through individual bonds or, more easily, through bond funds/ETFs
Laddering: This strategy involves staggering the maturity dates of your bonds. As one bond matures, you reinvest the principal into a new, longer-term bond, creating a continuous stream of income and managing interest rate risk
Lump-sum vs. dollar-cost averaging: Decide whether to invest a large sum at once or invest smaller amounts regularly over time
With Ally Invest, you can research and purchase bond funds or ETFs that fit your strategy. Our platform is designed to give you control and clarity, whether you're buying individual bonds or exploring bond funds.
Choosing the right bonds for you
The best bond investments for you depend on your individual financial goals, risk tolerance and time horizon. Bonds can be a foundational element of a resilient portfolio, providing stability and income.
