How to Buy Bonds: Where They Trade, What They Pay, and What Can Go Wrong

Stock ownership and bond ownership get grouped together as investing, but the mechanics have little in common.

A shareholder owns a slice of a company. A bondholder has lent money to a company or a government on terms set in advance, with interest often paid twice a year and the original amount returned at the end of the term.

That difference in mechanics is why bonds behave differently in a portfolio, and why they're bought through somewhat different channels than stocks.

Four Ways to Get Bonds Into a Portfolio

There's no single storefront for bonds. The realistic routes for an individual investor are:

• Open a brokerage account and buy individual bonds, bond mutual funds, or bond ETFs through it.
• Use an investing app on a phone or tablet, keeping in mind that the available bonds and bond funds differ from one app to the next.
• Work with a financial advisor, who can place the trades and also weigh whether individual bonds, a fund, or an ETF fits the situation.
• Buy Treasury securities straight from the U.S. government through TreasuryDirect, the Treasury's own site.

Of those four, funds and ETFs tend to be the least complicated for someone starting out. Treasuries are the one category you can buy from the issuer itself, with no intermediary in between.

Mutual Funds Pool Bonds, ETFs Trade Like Stocks, and Neither Has a Maturity Date

A mutual fund pools assets that share certain traits. An intermediate-term corporate bond fund, for example, holds investment-grade corporate bonds maturing in roughly a five- to 10-year window.

The variety is wide: there are funds holding only T-Bills, only high-yield bonds, or only municipal bonds issued in a single state such as California. Total bond market funds go the other direction, spreading exposure across a large slice of the fixed-income market.

Mutual funds are typically bought from the investment firm that runs the fund, through a brokerage account, or with an advisor's help.

A bond ETF aims at a specific piece of the market too. The difference is how it trades. Once the ETF's basket of bonds is assembled, the whole basket changes hands on the secondary market as a single security, the way a stock does.

The bonds inside move in price, and so does the ETF's own market price as buyers and sellers trade it.

One practical distinction is worth knowing. An individual bond has a maturity date; a fund holding many bonds does not. Hold a single bond to the end of its term and you know when the principal is scheduled to come back.

With a fund or ETF, you own shares whose price floats, and you exit by selling those shares at whatever they're worth that day.

Bonds Trade Over the Counter, Not on a Stock Exchange

The primary market is where securities are first issued: new stock offerings and brand-new bond issues.

t isn't especially open to ordinary investors. Most people buy on the secondary market, where existing securities change hands.

For stocks, the secondary market means named exchanges, including the New York Stock Exchange, Nasdaq, the American Stock Exchange, and overseas venues such as the London and Tokyo exchanges.

Bonds work differently. They're generally traded over the counter by large broker-dealers who buy and sell on behalf of clients, which is why very few everyday investors ever deal with that market directly.

One side effect is that bond pricing is usually less visible than the constantly quoted price of a listed stock, since no single exchange posts every trade.

Coupon Payments Along the Way, Principal at Maturity

Buying a bond means lending money, with the investor as the lender and the issuer as the borrower. Two things are settled before any money changes hands: how much interest the issuer will pay, and for how long.

Those interest payments are called coupon payments, and they usually arrive twice a year. When the term runs out, the amount originally lent comes back as well.

Bonds are called fixed-income securities because of that schedule. It's known at purchase, which is not how owning shares works; a stock's dividends and its price are both open questions.

Corporate Bonds Split Into Investment Grade and High Yield

Companies, public and private, issue bonds when they need cash for something specific: expansion, entering a new market, buying equipment, launching a product. Those issues sort into two broad buckets.

Investment-grade bonds have been rated favorably by one or more of the three major U.S. rating agencies, which are Standard and Poor's, Moody's Investor Service, and Fitch Ratings.

The scale runs AAA at the top, then AA, A, and BBB, with some agencies adding plus and minus designations.

High-yield bonds, also called junk bonds or non-investment-grade bonds, carry lower ratings, a signal that the issuer may struggle to meet its debt obligations.

Anything rated below BBB falls in this group, and there's real variation within it. The lower the rating, the greater the risk taken on, which is typically paired with a higher rate of return.

Municipal Bonds Fund Local Projects and Often Skip Federal Tax

States, cities, and counties issue munis to pay for approved local projects: a new school, a rebuilt highway or sewer system, a park, a neighborhood library.

Interest income from muni bonds is typically exempt from federal and local taxes for residents of the issuing municipality.

They come in three main forms:

• General obligation bonds pledge no particular asset. Behind them is the issuer's own credit and its commitment to repay, which is what "full faith and credit" describes.
• Revenue bonds get repaid out of the money a specific project takes in. Highway tolls and lease fees on a building are the usual examples.
• Conduit bonds involve a third party. A local government issues them, but the borrower is another organization, such as a hospital or a nonprofit college.

Treasury Maturities Run From a Few Days to 30 Years

Treasuries are issued by the Department of the Treasury and backed by the full faith and credit of the federal government, which is why they're regarded as the safest bond investments.

TIPS, or Treasury Inflation-Protected Securities, adjust their principal value as the consumer price index moves.

The value rises when inflation rises and falls when inflation falls. At maturity, the investor is repaid either the original or the inflated value, whichever is greater.

Lower Ratings Usually Mean Higher Interest Payments

A rating is a grade on the issuer's likelihood of making interest payments on time, or at all. AAA is the highest available and suggests the most stability. Ratings of BB and below point to higher risk of late or missed coupon payments.

The pricing follows from that. An issuer with a weaker rating generally has to offer more interest to attract buyers, so lower-rated bonds tend to carry higher coupon rates. Ratings also aren't permanent.

Agencies can revise them while a bond is outstanding, which is part of why two bonds with similar coupons can trade at noticeably different prices.

Five Risks That Come With Bonds

Bonds are generally treated as a lower-volatility holding, but they are not risk-free.

• Call risk is the issuer's option to buy the bond back and retire the issue, something that tends to happen when interest rates fall.
• Reinvestment risk turns up when a bond matures and the money coming back has nowhere as good to go. Principal returned from a bond bought 10 years ago at a 5% coupon, put back to work when the prevailing rate is 3%, leaves the investor 2% behind on future interest income, assuming the money is reinvested.
• Inflation risk erodes what the coupon buys. Payments on a bond issued at a 3% coupon rate lose real value while prices for goods and services climb at 4%.
• Supply and demand risk exists because plenty of owners sell over the counter well before maturity. Prices there respond to prevailing rates: as interest rates rise, secondary-market bond prices generally fall, and the reverse holds too. A bond paying a 5% coupon has to be discounted to interest a buyer who could instead take a newly issued bond paying 6%.
• Default risk sits at the far end of the list. An issuer in financial trouble may pay interest or principal late, or fail to pay it.

Why Bonds Sit Next to Stocks in a Portfolio

Risk tolerance and time horizon are usually what set the mix. Investors who dislike volatility, and those later in their careers, often lean toward a larger bond share; younger investors, or those comfortable riding out sharp market moves, often lean the other way.

Behind that choice is a difference in how the two behave. Stock prices can move a long way in a short time, while bond prices generally move less, and often in the opposite direction.

Stocks have tended to outperform bonds over long stretches, so the two allocations pull against each other: one for return potential, one for steadier pricing.

A portfolio holding both is what most financial professionals mean by diversified.

A Bond Ladder Spaces Out When the Interest Arrives

Another approach is a bond ladder: buying several bonds with sequential coupon dates, the dates when interest payments come due to the holder.

The point is to build a future income stream out of staggered payments rather than a single semiannual check.

Here's how that plays out. Someone who wants interest landing once a month across a 30-year retirement would need enough bonds, with coupon dates spread through the calendar, to cover every month.

So the number of bonds bought follows from how often payments are wanted, and for how long.

What a Fund Leaves You Holding and What an Individual Bond Does

The two routes end in different possessions. A fund or ETF spreads the money across many issuers, and what the investor holds is shares, sellable on any trading day at whatever price the market sets that day.

An individual bond narrows everything to one issuer, one rating, one maturity, one call structure, and reading each of those falls to the buyer. What the extra homework purchases is a date, plus a stated principal amount scheduled to arrive on it.

No fund carries a date, which is why the two don't substitute for each other even when the bonds inside look similar.