How to Invest in Bonds: A Step-by-Step Guide

By Maurie Backman Markets Fool.com

Investors have several options for growing wealth, and while many are drawn to stocks because of the earnings opportunities they offer, others take comfort in the safety of bonds. Bonds are debt securities issued by companies or entities to raise money. Because bonds typically make regular interest payments, they're a good way to generate a reliable stream of income. Bonds also come in a number of varieties -- namely, corporate or commercial bonds, municipal bonds, and Treasury bonds. If you're looking to get started with bond investing, here's a step-by-step guide that will teach you everything you need to know.

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Step 1: Understand the basics of how bonds work

A bond is a debt instrument issued by a company or entity in order to secure financing. When you buy bonds, you're basically agreeing to lend your issuer a certain amount of money for a fixed period of time. In return, the issuer promises to make regular interest payments at a predetermined rate until the bond matures, or comes due, at which point your principal is repaid in full.

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Now there are exceptions to this rule. Zero coupon bonds, for example, don't pay regular interest, but rather are purchased for a price that's lower than their face value. But for the most part, those who invest in bonds have the option to collect interest payments.

With that in mind, there are two ways to make money from bond investing:

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1. Holding bonds until they mature and collecting regular interest payments (typically semiannually)

2. Buying bonds at a certain price and then selling them for a price that's higher than what you initially paid

These two options need not be mutually exclusive. You could, for example, buy bonds, hold them and collect interest payments for several years, and then sell them when their market value increases.

Step 2: Decide which type of bonds to buy

Not all bonds are created equal. In fact, there are several types of bonds you might choose to buy:

  • Corporate bonds are those issued by companies to raise money for things like research and capital improvements. The interest you receive from corporate bonds is taxable at both the state and federal level.
  • Municipal bonds are those issued by cities, states, and other localities to finance public projects and increase public services. The interest you receive from municipal bonds is always tax-exempt at the federal level, and if you buy bonds issued by your home state, you can avoid state and local taxes as well.
  • Treasury bonds, or T-bonds, are those issued by the U.S. government. The interest you receive from T-bonds is taxable at the federal level, but exempt from state and local taxes.

Though there's generally no such thing as a risk-free investment, Treasury bonds, by nature, are considered to be virtually risk-free. Municipal bonds, though not risk-free, are considerably less likely to default than corporate bonds. On the other hand, corporate bonds tend to offer the most generous yields, so you'll need to weigh your desire to make money against your appetite for risk.

Step 3: Choose an investment horizon

While you're not required to hold your bonds to maturity, if the value of your bonds falls after you buy them, you may have no choice but to retain them long term to avoid taking a hit on your principal investment. That's a big reason why you'll need to put some thought into your ultimate investment horizon. Because bonds come with differing terms (10 versus 20 versus 30 years, for example), setting some investment goals can help you determine how long to potentially lock your money away for.

If you're going to load up your portfolio with bonds, you may want to consider a laddered approach, where you buy different bonds with staggered maturity dates. This way, you not only secure a reliable stream of interest income, but get more built-in liquidity, since you'll have different bonds coming due at various points in time. Remember, though bonds are thought to be safer than stocks, they're not traded as heavily, and so they're not quite as easy to sell on a whim. A laddered approach can therefore help reduce your liquidity risk.

Building a bond ladder can also help you protect yourself against interest rate risk. Remember, when you buy bonds, you're locking yourself into a given interest rate for a fixed period of time. By having your bonds come due at frequent intervals, you're giving yourself an opportunity to get out of the bond market and put your money elsewhere as better investment opportunities arise.

Step 4: Research your investments

You'll often hear people making statements like these: "Bonds are a safe investment, and stocks aren't." But it's rarely that simple.

While bonds are typically less volatile than stocks, choosing the wrong bonds could expose you to more risk than you may have bargained for. That's why it's important to look at bond ratings when choosing a company or municipality to invest in. The higher the rating, the less likely your issuer is to default on its obligations. On the flip side, bond investors tend to be rewarded for taking on more risk, so if you buy bonds from an issuer with a lower rating, you'll typically snag a higher interest rate.

If you don't want to shoulder the risk of buying individual bonds, you could always invest in a bond fund instead, which gives you instant diversification. Think about it: If you buy bonds from a single issuer and that issuer defaults, you're out of luck. But if you buy a bunch of bonds and a single issuer defaults, you'll continue to make money from the rest of the bonds in that pool. The downside of bond funds, however, is that your income stream will be less predictable, as you won't get those same steady interest payments that holders of individual bonds collect.

No matter your age, bonds can play a big role in helping you meet your investment goals. Just make sure to weigh the pros of cons of bonds versus other instruments so that your choices align with your ultimate objectives.

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