This is a lesson straight out of Investing 101. While everyone has a different investing philosophy, I don’t think anyone doubts the security of bonds. They may not hold the lucrative potential as other strategies, and you probably wouldn’t want to invest everything you have in them for this reason, but they also don’t share the risks that come with the promise of large percentage gains. Still, buying bonds isn’t as straightforward as you might have imagined, and there are several vital lessons to be learned before you spend a penny. We’ll look at the different ways you can buy bonds and the pros and cons of each. Most people who buy bonds have a much larger share in the stock market; I wouldn’t trust myself with my money, but if you think you’re that kind of person, here’s as good a guide as you’ll get on how to invest in the stock market.
And a bond is…?
A bond is a debt security. This means that you are lending money to a bond issuer; most commonly, the government, a corporation, municipality, or other federal agency or entity. It works just like a loan. In return for your money now, the issuer gives you a bond that is symbolic of a “promise” to pay you a predetermined rate of interest throughout the life of the bond. When the bond matures—five, ten, twenty years down the road—the issuer then repays you the face value (principal) of the bond.
The best investment advice anyone will ever give you is this: maintain a diversified portfolio. Don’t put all your eggs in one basket. The great thing about bonds is their consistency. Most bonds pay interest twice a year, so twice a year you can rely on a payout. In addition, when the bond matures, your capitol investment is returned to you in full. So only invest money in bonds that you don’t plan on touching. More and more people, as they approach retirement, are transferring their investments over to bonds; once you retire and you no longer have an income, you can’t afford a year in the stock market like 2008.
Fancy yourself more of a risk taker? Learn how to buy or invest in real estate in the post-bubble era.
Going After The Feds
The easiest bonds to buy are those sold by the federal government. These U.S. treasuries are sold at regularly scheduled auctions. The cheapest way to purchase them is to buy them yourself directly from the Treasury. You can also have a broker, or even a bank, purchase them for you, but a bank will charge you a fee, as will brokers depending on the nature of their billing practices.
Good news first. Buying bonds through a mutual fund gives you a lot of diversity. You may not own, say, ten bonds outright, but you’ll have a hand in hundreds of mutually owned bonds.
Further, instead of the semiannual payouts offered by the Treasury, dividends from mutual funds are paid monthly. So that’s a nice way to pad the monthly paycheck. You can also choose to have your dividends reinvested into the mutual fund automatically, and thus grow your share month by month. You can also reinvest that money into an emergency fund.
Now for the bad news. Whereas individual bonds are more or less set in stone, mutual funds are comparatively liquid, meaning you can sell them more easily for cash. This probably sounds like a good thing, and sometimes it is, but it comes with an awful side effect. That wonderful guarantee we talked about in which you’re principal is assured? Gone. That amazing, almost unheard of benefit of a fixed maturity? Gone with wind, my friend. Neither your principal nor that sweet monthly income is guaranteed. Kind of defeats the purpose, doesn’t it?
Not exactly. Mutual funds are incessantly buying and selling bonds to maximize profits, so there is certainly a reward for your risk. You can buy relatively safe mutual funds by looking for funds that offer low expenses and favorable total returns (choosing funds based on their yields can be misleading, FYI).
First things first. Buying bonds on your own that are not government issued is incredibly risky if you don’t know what you’re doing. For example, older bonds traded on the “secondary market” (that is, not through stock exchanges, federal entities, etc.) carry massive transaction costs that you don’t see. These transaction costs are the difference between what a bond dealer paid for them and the price he’s charging you. Needless to say, it’s easy to make a poor investment.
Therefore, when buying new, individual bonds, take advantage of the ability to get them directly from the source; there’s no other way to get them at a fair price.
Here are a couple ideas for investing in bonds:
- If you want a steady source of income, you have to be more conservative. Don’t buy bonds with terms shorter than one year or longer than ten. This is the perfect middle-ground. They yield more than bonds with shorter terms and are more stable than longer-term issues. Going back to investment law #1 (diversify), buy a variety of bonds; some with one-year terms, some with five, some with ten, etc. This will make your month-to-month payout more consistent.
- If you’re trying to rake the cash in, you’ll need a different, riskier approach. You’ll want to buy long-term bonds, those with maturity dates greater than ten years. But your interest can change dramatically. When interest rates rise, you’re portfolio is going lose value immediately. Then again, when interest rates fall, it comes right back.
My advice is to hash-out a plan with someone who specializes in this kind of thing, a broker or even some professional instruction on the bond market. Even if you don’t buy through a broker, a little extra advice could go a long, long way.