Should You Invest in Bonds?

How Do Bonds Work?

A bond is a debt security issued by a government or corporation to raise money. When you buy a bond, you're lending money to the issuer in exchange for regular interest payments and the return of your principal when the bond matures.

After being issued, bonds can be bought and sold on the secondary market, similar to stocks. While the interest payments and face value stay fixed, the market price can fluctuate based on supply and demand, time to maturity, current interest rates and the issuer's creditworthiness.

Here are some key bond terms worth knowing:

• Par value: This is the face value of the bond—typically $1,000—and the amount you'll receive from the issuer at maturity.
• Coupon rate: The interest rate the bond pays, usually fixed at issuance. Zero-coupon bonds are an exception: they pay no interest but sell at a discount, so you still earn a return at maturity.
• Yield: The return you earn based on the bond's current price. A 5% coupon on a bond trading at $900 offers a higher yield than the same coupon on a bond trading at $1,200. Divide the annual interest payment by the current price to get the current yield.
• Discount or premium: A bond trading below its par value is at a discount; one trading above par is at a premium.
• Bid and ask price: The bid is the highest price a buyer will pay, while the ask is the lowest a seller will accept.

Example: Say you bought a $1,000 bond with a five-year maturity and a 5% coupon rate. You might receive semi-annual interest payments of $25 for five years, then get your $1,000 back at maturity.

When Should You Invest in Bonds?

Bonds can serve as a useful safety net when other investments underperform, especially in the short term. But they can also play a role in a long-term investment strategy. Here are situations where bonds may make sense:

• You want to generate income. Bonds typically pay regular interest, which can provide a fixed income stream. This is especially helpful during retirement when steady cash flow matters more than aggressive growth.
• You need a more conservative portfolio. As you approach retirement, preserving what you've built often takes priority over maximizing growth. Financial advisors commonly recommend shifting more of your portfolio toward bonds as you near that milestone.
• You want diversification. Even if your investment goals are decades away, diversifying your portfolio by adding some bonds can reduce your overall risk. That way, a downturn in the stock market doesn't hit your entire portfolio.
• You want tax benefits. Certain bonds come with tax advantages. Municipal bonds, which are issued by state and local governments, are generally exempt from federal income taxes and often state taxes as well. Treasury bonds are subject to federal taxes but not state or local taxes.

Learn more: What Are Bonds?

When Not to Invest in Bonds

Bonds aren't the right fit for every investor or every situation. Here are some scenarios where you may want to think twice:

• You expect interest rates to rise. Bond prices and interest rates move in opposite directions. When market interest rates go up, existing bonds with lower coupon rates become less attractive, and their prices fall. If rates rise after you buy, you could end up with a bond worth less than you paid for it.
• You need the money before the bond matures. Bonds typically mature anywhere from four weeks to 30 years after issuance. If you sell before maturity on the secondary market, you may get less than you originally paid if prices have dropped.
• You're concerned about default risk. Bonds issued by entities with lower credit ratings offer higher interest rates, but they come with a greater risk of the issuer failing to repay you. Before buying, take time to understand bond credit ratings so you can weigh the tradeoff between yield and risk.

That said, none of this means bonds are off the table. Understanding the risks helps you invest more strategically, and some of these risks can be reduced depending on how you buy.

Learn more: The Pros and Cons of Buying Bonds

How to Buy Bonds

There are a few ways to purchase bonds, depending on your goals and experience level. Here's what to know about your options.

Go Through a Broker

You can buy individual government or corporate bonds through a brokerage account. Keep in mind that bonds are typically sold in whole units, and you can't buy fractional shares the way you can with some stocks.

Bonds may be purchased as new issues directly from the issuer or on the secondary market.

Learn more: How to Start Investing

Buy Directly From the Issuer

Treasury bonds and many municipal bonds can be purchased directly from the issuing government entity. The U.S. Treasury sells bonds through its TreasuryDirect platform via auction or retail order.

Buying corporate bonds in a primary offering is generally less accessible to individual investors than purchasing Treasuries or municipal bonds directly. Most individuals buy corporate bonds on the secondary market through a broker.

Invest in a Fund

Bond mutual funds and exchange-traded funds (ETFs) let you invest in a diversified basket of bonds rather than a single one, which reduces your exposure to any single issuer's default risk.

Funds are also generally easier to buy and sell than individual bonds. The tradeoff is that both types charge management fees, though passive ETF fees tend to be lower than those of actively managed mutual funds.

Learn more: ETF vs. Mutual Fund: What's the Difference?

Frequently Asked Questions

Build Your Financial Foundation

Bonds can be a smart addition to a well-rounded investment portfolio, especially if you're looking to generate income, reduce risk or prepare for retirement. The key is understanding how they work and how they fit into your overall financial picture.

While you're thinking about long-term financial health, it's also worth keeping an eye on your credit. A strong credit profile can open doors to better borrowing rates and financial flexibility. You can check your FICO^® Score^Θ for free through Experian and get personalized insights into what's helping or hurting your score.