How to buy bonds? The ultimate guide by Digimagg

You have several options for purchasing bonds, including through a broker, ETF, or directly from the U.S. government. There are various types of bonds, such as corporate, government, municipal, and zero-coupon bonds, each serving different purposes.

Bond investments involve lending money to a company or government instead of purchasing ownership stakes like stocks. Financial planners often recommend allocating a portion of your portfolio to bonds due to their lower volatility and relative safety compared to stocks. Bond funds, including mutual funds or exchange-traded funds (ETFs), are a quick way to gain exposure to bonds and are available for purchase through most major brokerages.

Where can one purchase bonds?

Purchasing bonds on the bond market may pose challenges due to the initial investment required. While most bonds have a face value of $1,000, there are methods to acquire them for less. Buying bonds can be done through a broker, an ETF, or directly from the U.S. government in $100 increments.

Brokerage

One option is to buy bonds through an online broker. Opening a brokerage account is the first step. Bonds can be purchased from other investors willing to sell. Additionally, you may obtain a discount by purchasing a bond directly from the underwriting investment bank during an initial bond offering.

An exchange-traded fund (ETF) usually invests in bonds from various companies, with certain funds concentrating on short-, medium-, or long-term bonds or offering exposure to specific industries or markets. Investing in a fund is advantageous for individual investors as it provides instant diversification, and there's no need to purchase in large increments.

What factors should you consider when purchasing bonds?

Investing in bonds offers two income-generating strategies. One approach involves purchasing bonds and holding them until maturity to receive both the principal and interest payments.

Evaluate bonds for your portfolio using the following three-step process:

1. Assess the borrower's ability to repay its bonds

This is crucial as it determines whether the company can fulfill its obligation to repay the borrowed money along with interest. By conducting research, you can gauge the borrower's capacity to meet its debt commitments.

Bonds receive ratings from credit rating agencies such as Moody's, Standard & Poor's, and Fitch. These agencies evaluate creditworthiness by assigning credit ratings to companies, governments, and their issued bonds. The ratings range from AAA (the highest) to lower grades, indicating the likelihood of the borrower honoring its obligations and the corresponding interest rates.

Corporate bonds

Apart from credit ratings, assessing a company-issued bond's safety involves examining its interest payments relative to its income. Corporate bonds typically offer higher interest rates than government bonds due to their higher default risk. If a company lacks sufficient income to support its payments, it could encounter financial difficulties, akin to a homeowner struggling with mortgage payments.

Begin by reviewing the company's recent annual operating income and interest expense, which can be found in its income statement. This information is available for all publicly traded U.S. companies in their 10-K filings, on their websites, or in the EDGAR database on the U.S. Securities and Exchange Commission's website. Operating income, excluding interest payments and taxes, provides the best insight into a company's debt-paying ability.

Government bonds

Evaluating government-issued bonds is more complex, as governments typically lack substantial excess revenues indicating stability. However, government bonds, particularly those issued by the U.S. federal government, are generally considered safer for investment, often referred to as Treasury Bonds or T-bonds. These bonds are regarded as risk-free investments, offering lower interest rates due to minimal default risk. Exceptions include Treasury Inflation-Protected Securities (TIPS) and I bonds, whose rates adjust based on inflation.

Municipal bonds

While historically considered safe, bonds issued by cities, states, and municipalities may not be as secure. The Electronic Municipal Market Access (EMMA) site provides valuable information, including a bond's official prospectus, issuer's audited financial statements, and financial disclosures. Monitoring a government's credit rating and any recent defaults or financial issues is advisable. Additionally, income from municipal bonds is typically tax-free at the federal level and sometimes at the state level if purchased in the investor's resident state.

Zero-coupon bonds, also referred to as "deep discount" bonds, are bonds that do not pay periodic interest. Instead, they are sold at a discounted price relative to their face value, and investors realize a profit upon the bond's maturity. Examples of zero-coupon bonds include Treasury bills (T-bills).

2. Should I purchase bonds at this time?

Determining the opportune moment to purchase bonds involves assessing various factors. Once a bond's interest rate is established and offered to investors, it enters the debt market, where its price fluctuates based on prevailing interest rates.

Typically, bond prices move inversely to interest rates. In periods of economic expansion, interest rates rise, leading to lower bond prices or potential market crashes, as observed in 2022 and 2023. Conversely, during economic downturns, interest rates decline, causing bond prices to rise. While it may seem advantageous to buy bonds when prices are low during economic booms and sell them as the economy recovers, the situation is more nuanced.

Attempting to predict future rate movements can be challenging. Waiting for an ideal buying opportunity may entail trying to time the market, which is generally discouraged. To mitigate this uncertainty, many investors employ a strategy called "laddering." This involves acquiring multiple bonds with varying maturity dates spread over several years. As bonds mature, the principal is reinvested, gradually expanding the ladder. Although laddering may result in lower yields, it effectively diversifies interest-rate risk.

3. Which bonds are suitable for my portfolio?

Determining the appropriate bonds for your portfolio depends on various factors such as your risk tolerance, tax circumstances, investment horizon, and income requirements. A well-balanced bond allocation may encompass different types - including corporate, government, and municipal bonds - to diversify the portfolio and mitigate principal risk. Investors can also spread out the bond maturities to alleviate interest-rate risk.

Creating a diversified bond portfolio can be challenging due to the typical $1,000 increment at which bonds are sold, requiring substantial cash investment. Alternatively, investing in bond ETFs is a simpler option. These funds offer diversified exposure to desired bond types, allowing investors to mix and match ETFs even with smaller investment amounts. Broadening exposure through ETFs also reduces the risk associated with overconcentration in a single asset.