Stocks and bonds are both investments, but they work very differently. When you buy stock, you own part of a company. When you buy a bond, you're essentially lending money to a company or government under specified repayment terms.
Bonds can potentially provide income and help diversify a portfolio, but they're not risk-free. Before investing, it helps to understand the different types of bonds, how you can buy them, and what can affect their value.
Understand the Main Ways to Buy Bonds
You don't need to purchase individual bonds to add fixed-income investments to your portfolio.
Common approaches include:
- Buying individual bonds through a brokerage
- Investing in bond mutual funds
- Purchasing bond ETFs
- Buying eligible government securities directly from the government
Investment apps and financial professionals may provide additional access, although the selection of securities varies.
For beginners, bond funds and ETFs can provide a relatively straightforward way to spread an investment across multiple securities.
Know the Difference Between Individual Bonds and Funds
An individual bond generally has a maturity date. If the issuer meets its obligations and you hold the bond until maturity, the principal is scheduled to be returned according to its terms.
Bond funds work differently.
A mutual fund or ETF may own many bonds with different issuers and maturity dates. The fund itself generally doesn't mature, so you exit by selling your shares at their current value.
This distinction matters if you're investing for a specific future date and expect a particular amount of principal to become available.
Learn How Bond Income Works
When you purchase a traditional bond, the issuer generally agrees to pay interest according to specified terms and return the principal at maturity.
These interest payments are commonly known as coupon payments. Many traditional bonds make payments twice per year, although terms vary.
Don't assume the coupon rate tells you everything about your potential return. The price you pay for the bond, its maturity, credit quality, call provisions, and prevailing interest rates can all affect the investment's overall economics.
Compare Major Types of Bonds
Different issuers create different types of fixed-income securities.
Corporate bonds are issued by companies seeking to raise money. Credit quality can vary considerably, with lower-rated bonds generally offering higher yields to compensate investors for taking greater credit risk.
Municipal bonds are issued by state and local governments or related entities to finance qualifying projects. Certain municipal-bond interest may receive favorable tax treatment depending on the bond and investor's circumstances.
Government securities can offer maturities ranging from very short periods to decades, providing options for different investment horizons.
Pay Attention to Credit Quality
Credit ratings attempt to assess an issuer's ability to meet its financial obligations.
Higher-rated bonds generally carry lower perceived default risk, while lower-rated bonds usually need to offer higher potential yields to attract investors.
That higher yield isn't free money. It's compensation for taking additional risk.
Ratings can also change after you purchase a bond, potentially affecting its market price.
Understand Interest-Rate Risk
Bond prices and market interest rates generally move in opposite directions.
Suppose you own a bond paying a lower rate than newly issued comparable bonds. If you want to sell before maturity, potential buyers may require a lower purchase price to make the older bond competitive.
Longer-term bonds can be particularly sensitive to changing interest rates.
If you're holding an individual bond to maturity, short-term price fluctuations may matter less, but you'll still need to consider inflation, credit risk, and the opportunity cost of having money committed at a particular rate.
Don't Assume Bonds Are Risk-Free
Bonds may experience less price volatility than stocks in some circumstances, but several risks remain.
These can include default risk if the issuer cannot meet its obligations, inflation risk when rising prices reduce purchasing power, call risk if an issuer repays a callable bond early, and reinvestment risk if returned money must be invested at lower prevailing rates.
Bond funds can also lose value, particularly when market interest rates change.
Consider a Bond Ladder
A bond ladder involves buying multiple individual bonds with different maturity dates.
Instead of having your entire fixed-income allocation mature at once, portions become available at different times. You can then potentially spend or reinvest the proceeds depending on your needs and prevailing rates.
A ladder may help manage reinvestment timing, but it doesn't eliminate interest-rate, inflation, or default risk.
It can also require more planning than simply owning a diversified bond fund.
Think About Bonds as Part of Your Portfolio
Bonds are commonly used alongside stocks because the two asset classes can behave differently under changing market conditions.
However, there's no universal stock-to-bond allocation that's appropriate for everyone.
Your investment horizon, financial goals, need for income, ability to tolerate losses, and other assets can influence how much fixed-income exposure makes sense.
Diversification can help manage certain portfolio risks, but it doesn't guarantee positive returns or prevent losses.
Choose the Bond Strategy That Fits Your Goals
Individual bonds and bond funds solve different problems.
A diversified fund can spread your investment among numerous securities while simplifying management. An individual bond provides specific terms, including an issuer, maturity date, coupon structure, and scheduled principal repayment, assuming the issuer meets its obligations.
Before investing, compare credit quality, maturity, yield, fees, tax treatment, liquidity, call provisions, and interest-rate sensitivity. Understanding what you're actually buying—and why it belongs in your portfolio—is more important than simply choosing the investment offering the highest advertised yield.
