What to Know When Buying Bonds for the First Time

While stocks typically garner more attention, lately there has been a lot of talk about bonds. Most of the recent conversations have been negative. Nevertheless, bonds have a place in everyone’s portfolio. Here is what to know when buying bonds for the first time.

When you purchase a bond, you are lending money to the borrower in exchange for interest payments and the promise to return your principal at maturity. This is true whether it is a government, municipal or corporate bond.

The size of the interest payments you receive will depend on the borrower’s credit rating and how long you are lending them the money. For example, lending your money to the United States government is considered very low risk, so U.S. Treasury Bonds offer lower interest rates to bond buyers. In contrast, lending your money to a poorly rated corporation with a negative business outlook would be considered very high risk. Since a corporation with a poor rating is much less likely to pay back your principal, the only way it can entice you to buy its bonds is by offering a very high interest rate.

It is generally best to hold a bond until its maturity date. If you need to sell before that maturity date, it is important to understand that the value of a bond — meaning the price you could sell your bond for in the open market — can fluctuate based on changing interest rates.

For example, if you purchase a bond for $1,000 that pays a 5% interest rate, you can expect to receive $25 every six months and, at maturity, you will get your $1,000 principal back. But what happens if the Fed raises interest rates after you purchase your bonds and new bonds from that same issuer now offer bond investors 6%? The value of your bond would have to adjust lower so that the buyer would earn the same 6% on that bond that an investor could receive from buying a new issue. Remember, the interest rate is fixed, so no matter what happens, the bond you own will pay that $25 every six months and return a $1,000 principal at maturity. Therefore, the value, i.e., price, must drop to $800 so that when the new buyer pays $800 and receives $25 every six months, the bond yields the equivalent of 6%.

How much your bond’s value would need to adjust to a changed interest rate would depend on how long that bond has left before maturity. If you are supposed to get your principal back in one year, there will be a slight change in your bond’s price. But if you must wait 20 years, your bond will lose a lot of value. Think of bond values and interest rates as if they are on opposite sides of a seesaw. When interest rates go up, bond values drop, and when interest rates go down, bond values go up. The farther out they sit on the seesaw, the bigger the impact!

Does this make bonds bad investments? Absolutely not. If investors can hold their bonds until they mature, the investors will receive their entire principal back. That principal payment is what makes bonds less risky than buying common stocks. Bonds are higher up on a company’s capital structure, so if a company were to go bankrupt, the bondholders would get paid back before any stockholders would.

So how should you invest in bonds? As with stocks, hiring a professional to buy individual bonds is usually best. Alternatively, you can invest in bonds through an exchange-traded fund (ETF) or mutual fund. By buying an ETF or mutual fund, you get instant diversification, meaning if one of your bond holdings inside the fund were to default, you would not lose all your investment. Take note that when buying bond ETFs or mutual funds, there is no return of principal; the bonds inside the funds continually mature, and the fund managers use the proceeds to buy new bonds.

How much you should own in bonds will depend on your willingness and ability to take risks, along with your time horizon for retirement. Older and more conservative investors will have a higher percentage of their portfolio in bonds than their younger and more aggressive counterparts. Traditionally, younger and more aggressive investors could have as little as 10% of their portfolio in bonds, while older and more conservative investors may have as much as 90%. When deciding how much to allocate to bonds, you must understand what return you need during your working years or retirement to achieve your financial goals. Even in retirement, you should not avoid stocks entirely because they will help you outpace inflation, while bonds and cash-like investments typically will not.

Ready to look into buying bonds? Find your CFP® professional today to help you get started.