Financially reviewed by Patrick Flood, CFA.
Bonds are a critical part of a diversified investment portfolio alongside stocks, lowering volatility and risk. Here we’ll explore what a bond is, why you’d want to invest in bonds, types of bonds, and how to buy bonds online.
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In a hurry? Here are the highlights:
- A bond is an instrument by which lenders/investors are paid periodic interest payments for providing a loan to the bond issuer.
- Companies and governments issue bonds to finance projects and operating expenses.
- A bond’s market value fluctuates based on interest rates, credit rating, and time to maturity.
- Longer-term and lower-credit bonds are riskier – and thus typically exhibit higher returns – than shorter-term and higher-credit bonds.
- Bonds are an important part of a diversified long-term investment portfolio. Bonds can provide a stream of regular income for income investors, and/or a hedge for stock positions due to their uncorrelation to stocks.
- There are several types of bonds with different behaviors and varying levels of risk.
- Bonds are usually bought via bond index funds, but can also be bought individually through a broker or directly from the U.S. government.
What Is a Bond?
A bond is simply a loan that usually pays back a fixed rate of return to the lender over a specified time period. This is why they are called a “fixed income” investment. Technically, the bond itself is the promise of repayment of the loan and can be thought of as an I.O.U. detailing the arrangement of the loan.
Lenders in this case are investors, and borrowers are companies, governments, or agencies. These borrowers issue bonds to finance projects and operations. For example, governments issue bonds to pay for schools, roads, etc. Corporations issue bonds to borrow money to grow their business. These bonds are then traded by investors on secondary markets after the original borrower has raised capital.
For the investor, in the context of investing in the stock market, bonds are a crucial ingredient in a long-term diversified portfolio, especially for risk-averse investors. Different types of bonds have different levels of risk, but bonds in general are considered less risky than stocks.
Now you know what a bond is. Let’s look at how bonds work.
How Do Bonds Work?
Bonds pay periodic interest payments (called a bond’s coupon payment) based on a set interest rate (known as the bond’s coupon rate) over a specified time period (known as the bond’s maturity). Essentially, the loan is paid back plus interest after the bond has reached maturity. For a simplistic example, a $1,000 bond with a 5% coupon rate and a 5-year maturity will pay the lender $50 per year for 5 years, after which the original principal of $1,000 – known as the bond’s par value – is repaid.
Bonds are bought and sold as investments. The market value of a bond fluctuates based on creditworthiness of the issuer, time to maturity, and coupon rate. Bonds from low-credit-rating issuers typically pay a higher interest rate because the greater risk of default makes the bonds more risky; these bonds are called “high-yield bonds” or “junk bonds.” Longer-term bonds usually pay a higher interest rate because their greater exposure to interest rate risk and inflation risk makes them more risky than short-term bonds. This sensitivity to interest rate fluctuations is known as a bond’s duration. The rate of change of that sensitivity is called convexity. I wrote about choosing a bond duration here. I explored bond convexity here.
Now that you know how bonds work, let’s look at why one might want to invest in bonds.
Why Invest in Bonds?
As you’ve seen, one reason one might buy bonds is for a steady stream of income from interest payments. This makes bonds particularly attractive for income investors and retirees. The other, more common reason to invest in bonds is to lower the volatility and risk of stocks in a long-term investment portfolio.
On average, bonds are less volatile and less risky than stocks, providing more stable, predictable returns, and are thus considered a safer investment. But by investing solely in bonds, you’d miss out on the historically-higher returns of stocks. Conveniently, bonds and stocks are uncorrelated, meaning when stocks zig, bonds usually zag, and vice versa. This is why bonds are the primary diversifier of choice alongside stocks. In this way, bonds also act as insurance or a “hedge” against stock crashes, as bonds are typically a “flight to safety” asset.
This relationship between stocks and bonds is particularly important for investors with a short time horizon, retirees, and investors with a low risk tolerance. A young investor with a long time horizon and a high tolerance for risk can afford to invest 100% in stocks and go without bonds for a while. A retiree at age 60, on the other hand, will likely have an asset allocation of at least 20-40% bonds.
Now that you know why to invest in bonds, let’s look at the different types of bonds and how to buy them.
Types of Bonds
There are several different types of bonds:
Corporate bonds are issued by corporations to finance future growth. Corporate bonds provide income as long as the company is able to pay its debts. Corporate bonds typically have slightly higher yields than government bonds, but don’t provide as much downside protection for stock crashes. “High-yield” or “junk” bonds are corporate bonds. High-yield bonds are a major part of the bond holdings in the dividend portfolio I designed for income investors.
Government Bonds (Treasury Bonds)
Government bonds, or treasury bonds, as the name implies, are issued by governments to finance projects and operations. Treasury bonds are the safest, most stable type of bond. Treasury bonds have a lower correlation to stocks than corporate bonds, and are thus a superior hedge in a diversified portfolio. I wrote a separate post about government bonds vs. corporate bonds here. Interest from treasury bonds is usually tax-free at the state level.
Municipal bonds, or munis for short, are issued by states and municipalities, and usually have coupon payments that are exempt from federal income taxes. Because of this tax savings, yields from munis are usually lower than other bonds.
How to Buy Bonds Online – 3 Ways
There are several ways to buy bonds online:
- Through a broker – You can buy individual bonds through some online brokers, which connect investors who own bonds and want to sell them with investors who want to buy them. Note that most bonds are usually sold in increments of $1,000 which can make it hard to buy individual bonds with a lower amount of capital.
- From the U.S. government – You can buy individual bonds directly from the U.S. government via TreasuryDirect.gov.
- Through index funds – The easiest and most popular way to invest in bonds is simply through bond index funds – mutual funds or ETFs (exchange-traded funds) – via a broker. This route provides immediate diversification, providing exposure to many different bonds with different maturity dates. Below are some of the most popular bond funds and their ticker symbols.
How to Buy Bonds Online – 6 Popular ETFs
Below are 6 popular bond index funds, all from iShares:
- AGG – iShares Core U.S. Aggregate Bond ETF
- LQD – iShares iBoxx $ Investment Grade Corporate Bond ETF
- HYG – iShares iBoxx $ High Yield Corporate Bond ETF
- IEF – iShares 7-10 Year Treasury Bond ETF
- TLT – iShares 20+ Year Treasury Bond ETF
- MUB – iShares National AMT-Free Muni Bond ETF
Where to Buy These Bond ETFs
All these bond ETFs are available on M1 Finance. The online broker has zero transaction fees and zero account fees, and offers fractional shares, dynamic rebalancing, and a modern, user-friendly interface and mobile app. I wrote a comprehensive review of M1 Finance here.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.
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Rick Stein says
If you wouldn’t mind entertaining a question regarding Treasury Bonds in a retirement portfolio it would be greatly appreciated. Having spent some time in FOLIOvisualizer (free) and hacking out a retirement folio and I ran across what seems to be a paradox regarding bond weighting. Portfolio investment allocations are as follows:
ITOT iShares Core S&P Total US Stock Mkt ETF 34.00%
VEU Vanguard FTSE All-Wld ex-US ETF 14.00%
SPTS (SPDR Portfolio Short Term Treasury ETF) 4.00%
SPTI (SPDR Portfolio Intmdt Term Trs ETF) 8.00%
SPTL (SPDR Portfolio Long Term Treasury ETF) 12.00%
BNDX Vanguard Total International Bond ETF 8.00%
VTEB Vanguard Tax-Exempt Bond ETF 8.00%
OUNZ VanEck Merk Gold Trust 12.00%
I choose to allocate Treasuries to three(3) individual ETFs to make it easier to spread the investment across two different taxable accounts held at different brokerages. Not really knowing how to use FolioOptimizer and working only with engineering intuition…. my approach was first to isolate Sigma and find the allocation most consistent at achieving a Sigma=7.0. Then, I switch to isolating Returns and finding the allocation most consistent at achieving a Cagr=11.0. My strategy was that a stable desirable portfolio performance would lie somewhere between these two extreme points. End results were encouraging and seemly satisfactory. However, you will notice weight scaling of the three(3) treasury bond terms, Short/Interm/Long which the Optimizer weighted towards the Long-term Bond. This was the case for when finding Sigma as well as optimizing for Returns. I have some but limited understanding of Bonds and this weighting toward the Long-term Bond seems counter intuitive? Most portfolio examples that break down treasuries in this way seem to follow an equal weight strategy. Should I be concerned over this optimized weighting?
Portfolio= [email protected]
Initial Balance= $10,000
Final Balance= $16,349
Best Year= 19.09%
Worst Year= -3.27%
Max. Drawdown= -8.02%
Sharpe Ratio= 1.19
Sortino Ratio= 2.14
US Mkt Correlation= 0.89
John Williamson says
Rick, sounds like you’re overthinking it. No need to split up the treasury ETFs; I’d pick a duration that roughly matches your time horizon and use the single ETF for that and call it a day.
Are you saying you’re surprised that a diversified portfolio with long bonds outperformed one with short bonds? We would expect this, as the greater volatility of long bonds is better able to counteract the downward movement of stocks. I touched on this concept here and here.