How to Invest in Bonds

Bond investing is a complicated topic. I recently spent some time to really learn and dive deep into the world of bonds and I can flat out say its sucks.

That is unless you like fancy financial math (I do) and being absolutely boring (I don’t). So for me its a mixed-bag of feelings.

Anyone with any type of financial knowledge is going to have an opinion on bonds. Bond investing is quite the controversial topic. Depending on your age, where you are in your career, and how close you are to retirement all effect how you’ll feel about bonds.

However, we as generational wealth builders, need to understand bond investing because its another great tool to have in our belt.

So here are the concepts to know to get started in bond investing:

Bonds are a way to invest in someone else’s debt.

Bonds are fixed-income security and offer you the ability to invest in someone else’s debt in exchange for regular interest payments and return of your initial investment at bond pay-off (aka maturity).

Think of it is as an IOU.

Another great example is a mortgage (or promissory note) from a bank. You mortgage (bond) your house so that you can own an asset (the house). The bank in turn receives an agreed upon payment each month that is backed by a physical asset (aka the house you live in) for a defined period of time.

Not all bonds are created equal.

Just like with people and their credit ratings, bonds have a credit rating as well. That credit rating ranges from, very good or also called investment grade (BBB- or higher) to junk bonds also called high-yield or non-investment grade (BB+ or lower) (click here for more info on the different ratings).

Bonds also have credit rating reporting agencies. Moody’s, Standard and Poor or S&P, (yes that same S&P you’re thinking of), and Fitch. These agencies do the hard work and determine the ability of the company or government to repay their debt (bond) and set the rating. Thus if you are poor candidate for credit, you end up with a worse rating or score.

Bonds typically move with interest rates.

When interest rates rise, it becomes harder borrow money and as a result bond prices fall. Theoretically this is supposed to happen in reverse as well, however we have low interest rates today and the bond market is garbage. Nevertheless this is the general concept you should know and keep in mind when evaluating bond investing.

Bonds can help prop up your portfolio when the stock market is down.

For the past 20 years, when U.S. stocks have gone up, U.S. bonds have generally gone down — and vice-versa. This is good theoretically because a portfolio of bonds and stocks can serve as a buffer for a bad time in stocks or bonds. That balance serves to prevent your investment portfolio from taking wild swings and decreasing the volatility, which is good.

This isn’t a hard and fast rule however, so don’t forget to keep an eye on how bonds prices are responding to market changes.

Bonds can be a safe investments.

Treasure Inflation Protected Security (TIPS) is a bond that is tied to inflation so the value of it increases as inflation increases and the interest payment will fluctuate. TIPS are often talked about or use as the risk-free (nothing is truly risk-free by the way) investment as its backed by the U.S. Treasury and thought to be the “safest investment out there.”

TIPS are one example of a “safe” type of investment, others are savings bonds (EE or I-Bonds) and these types of bonds can be bought directly on Treasury Direct.

Jason Zweig from the Wall Street Journal and of The Intelligent Investor fame, wrote an excellent primer on I-Bonds that you can check out here.

However remember some of the risk of bonds depends on the quality of who is requesting the money. The U.S. is thought to be a better credit risk than a random country in the middle of nowhere trying to prop its economy up with your money however this is debatable at times as well.

No matter what, remember there is no such thing as an investment without risk.

Bonds have different durations (timeframes for payback).

Just like with a 30 year mortgage, bonds have an expected duration or payback time (maturation). The longer the duration, the more the bond is exposed to the risk of interest rate fluctuations. Another way of saying this, is the longer the duration the greater the risk of whomever took out the bond defaulting on paying it back.

The risk-reward payoff matters here, but you need to pay attention and understand your risk profile.

What is the best way to invest in bonds?

I may be biased but as a retail or do it yourself investor, you likely don’t have enough time to research every bond (or every stock) and evaluate it properly. You have to give something up. Either concentrate your bet (very risky), choose someone else to do it (mutual fund or ETF), or try to diversify on your own.

To add to the complexity of bond investing, there is the alphabet soup of nomenclature and language that takes a long time to become fluent in for something that doesn’t provide a robust return.

The best answer here in my opinion is to buy a bond ETF (or mutual fund) and let someone else deal with the headache.

Bond funds sometimes contain hundreds (or thousands) of bonds and as a result, this diversification can help decrease the risk of owning a individual bonds. Investing in a bond funds uses the same rationality as investing in index funds.

Diversification is your friend with bond investing.

Personally I am not a huge fan of bonds however I do have exposure to bond funds (very small) via my children’s UTMA accounts.

With regards to ETFs or funds in general, I tend to be a huge fan of Vanguard.

Because who isn’t?

Whatever you decide, try to pick a low cost bond ETF that matches your risk profile.

Lastly, bonds do have a place in your portfolio whether you like them or not and regardless of your age and risk profile. You may not be the classic 60/40 type person (40% bond exposure) but bonds are a necessary element because despite popular belief, “Stonks don’t always go up.”

As always if you have questions or concerns regarding creating an emergency fund, investing, real estate, insurance, or planning for the future, don’t be afraid to speak with qualified financial advisor. Smart Asset has a great tool to find an advisor in your area or feel free to email me (contact@surgifi.com) to help you on your path to financial independence.