Bonds! A 3 Step Guide to Making Your First Purchase…

Last week, I offered a brief overview of the bond market. We talked about what a bond is and why you might want to consider adding some to your portfolio. This week, let’s take it a step further by discussing how to research different types of bonds, and bond funds, and then ultimately take the next step by making some investments!

Before we get started, let’s review some basics of bond investing:

There are essentially 3 different types of securities to consider

  1. Regular (coupon) bonds — A company or government issues debt in the form of bonds; when you buy a bond, you are regularly paid (generally on a semi-annual schedule) a certain amount (the coupon) throughout the time it takes a bond to mature. If you need a refresher about coupon payments, here is last week’s piece on bond basics!
  2. Z-bonds — A z-bond is a “zero-coupon” bond. When you purchase a z-bond for the sake of holding it long term, the only money you make is described by the yield after the bond matures. For example, let’s say you purchase a $1,000 bond with a 10-year maturity for $900. At the end of the 10 years, you’ll make $100, which means that the final yield of the bond will be 11.11%.
  3. Bond funds — If you want to invest in a diverse range of bonds, but don’t have the cash to buy all the bonds individually, bond funds are going to be your best bet. It’s like an ETF, except for bonds! 

Great! Now that we have that understanding, let’s review the 2 different strategies for bond investing: 

  1. Buy and hold — Due to the nature of bonds, the buy and hold strategy is very popular. Assuming you invest in credible bonds (i.e the company or government responsible for issuing the bond isn’t likely to default on the debt), you’re pretty much guaranteed to make money.
  2. Active management — The price of bonds, like stocks, fluctuates according to interest rates, and risk factors. Generally speaking, a higher interest rates lowers the price of existing bonds. To illustrate this point, consider Joe who bought a $1,000 bond with a 5% interest rate from Apple. Six months later, Apple decided to raise the interest rate to 7%. All of the sudden, the 5% bond that Joe bought isn’t very attractive any more so Joe decides to sell it for $900 in order to free up cash to buy the 7% bond. On an open bond market, there are millions of Joe’s who are constantly buying and selling. Thus, an opportunity is created to take advantage of price fluctuations.

Step 1: What Type?

So the first step in buying bonds is to figure out what type of bond you want. Here are you options, in terms of domestic bonds, listed in order of ascending risk (and therefore return).

  1. Treasury bonds — Also known as “T-bonds.” For most of contemporary history, the United States treasury bond has essentially been considered to carry zero risk, although that seems to be changing very gradually. Especially with the current administration’s apparent attitude towards default, a lot of people are worried that the US might not be as safe as once thought. For right now though, if you’re looking to just hold your money in a financial instrument that at least keeps up with inflation (the current US 10-yr yield is 2.25%), than a T-bond might be your best pick. Income from T-bonds is exempt from state and local taxes, although not federal taxes.
  2. Municipal Bonds — Cities and counties and such are more likely to default that than the federal government, but still present a relatively safe bond opportunity. Because of the heightened risk, you’re likely going to receive a slightly higher interest rate than what you might expect from a T-bond. The yield of municipal bonds varies greatly, but here’s an example of several New York municipal bonds, which carry yields of between 4-6%.
  3. Corporate Bonds — In general, private companies are much more likely to default on debt than governments in the United States (this is not necessarily true when considering foreign governments, but that’s another conversation…). The risk carried by corporate bonds, and indeed all bonds, is captured by the bond “credit rating,” which can be issued by several large rating companies. The most trusted sources of credit ratings are Moody’s, Standard & Poor’s, and Fitch. The best credit rating is AAA; as you move down the scale (AA, A, BBB, BB, B, CCC… etc) the risk of default increases. Corporate bonds with lower credit ratings generally have higher yields. You can check out some examples of corporate bond quotes from the New York Times!

As a side note here, you also have the option of investing in bond funds, which are essentially ETFs for bonds. Investing in bond funds will allow you to gain exposure to a diverse array of bonds, which can limit the risk of default on any single security and allow you to achieve greater returns from your capital.

A particularly interesting application of bond fund investing is to utilize it to gain diverse exposure to emerging bond markets. Across the world, the emerging bond market is largely viewed as a very exciting opportunity, which is poised to achieve handsome returns in the medium term. I’m personally going to go out to do some research on the best emerging market bond funds and start adding several of them to my portfolio. When I make a decision on which funds they will be, I’ll let you know!

Step 2: Initial and Ongoing Research

Before purchasing any bonds, you need to go out and do your research. At a minimum, you need to determine the values for:

  1. Bond Yield 
  2. Coupon Rate
  3. Credit Score 
  4. Maturity Date
  5. Coupon Payment Schedule
  6. Par Value 
  7. Current Price

on each of your investments.

Once that’s done, and you’ve gone out and purchased your bonds, it’s a good idea to stay up to date on any relevant information that may affect the value or risk associated with your bond. For example, if you you’re holding a corporate bond and the credit rating is suddenly lowered, you may want to sell the bond and move on to something else.

In order to stay up to date and have access to all of this data, I recommend subscribing to a market research service such as the Wall Street Journal or the New York Times. I personally use the Wall Street Journal, and have been very happy with their service.

Step 3: Building a Bond Ladder

Once you’re ready to start investing, building a bond ladder refers to staggering out the maturity dates of your bond investments so that you don’t end up in a situation where you’ve bought a bunch of bonds that you don’t want to / can’t sell for whatever reason.

While we’re on the topic:

You may not be able to sell your bond immediately because bond trading has significantly less volume than stock trading.

You may not want to sell your bond because the value of your bond has fallen since you bought it and you do not want to take a hit on the invested capital.

So in order to mitigate the effects of both of those possibilities, it’s a good idea to stagger the maturity dates of your bond purchases so that you have a steady stream of liquidity and predictable payments coming your way throughout your bond holding experience.

If you’ve decided to buy a mix of T-bonds and corporate bonds, great! Just don’t go out and buy all of them with a maturity date in 2037 and then plan to sit around for 20 years while all of that capital is tied up in the bond market. 20 years is a long time, and you may want an out at some point.

In order to complete the transaction, you’ll need to sign up for a brokerage service other than Robinhood. Head over to our recommended brokers page to learn more about different broker options and to make your selection!

So that’s it for this week’s step by step process on investing in bonds. If you follow these three steps, you’ll be well on your way to becoming a bond pro!

Until next time, happy investing!

Kristian Gaylord

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