Bonds can definitely be a confusing investment option.
The stock market is so easy to understand, you buy 1 or more stocks in a company you think will succeed, and you reap the benefits if it does. You pick when you want to cash out, and go find another stock.
Bonds are a bit different, but that doesn’t mean they shouldn’t be a part of your diversification strategy. Bonds can actually help hedge some of that heavy risk you take on when buying stocks.
My goal in this post is to extensively help you understand what a bond is, how it works, and cover the different key terms used in a bond market.
I hope to do this as simply as possible, let’s get started!
What is a bond and how does it work?
A bond is a loan that a large organization or government issues. You can buy bonds for big names like Apple, and also a bond for a public project in a city like Boston.
An individual bond loan value can be massive, like many millions to billions of dollars. It’s usually a really big undertaking from a private company or city/state project that needs lots of funding.
When you buy some bonds, you’re now called a debt-holder or creditor.
Bonds works like this:
- A company, let’s say Apple, wants to build a huge new headquarter, for say $100 million.
- After approval, they issue bonds to the public, promising to pay the bond back entirely on an agreed-on date.
- You can buy 1 or more bonds for this project, and get interest payments based on the agreed on interval period (could be monthly or quarterly). The rate that you get paid back could also be fixed or variable, be sure to examine that during your review.
- You can hold the bond until the maturity date (end-date) or buy/sell in a secondary market for bonds. Because of this feature, the value of your bond can go up and down until maturity.
What are the different bond ratings?
The cool thing about buying bonds is that they get a rating from as high as AAA to as low as D.
Credit rating agencies like Standard & Poor’s and Moody’s are in charge of researching and giving each bond a rating based on how likely they are to repay their loan.
- Strong bonds get AAA and usually have a lower but more predictable return.
- Riskier bonds get lower ratings and have higher return potential, but also the potential to default.
I like Wikipedia’s page on bond ratings, it’s the most convenient to quickly review the different bond ratings.
What are EE bonds or I bonds, which one is better?
This is an interesting area on bond investing because they’re pretty low risk and really long term investments.
Series EE Bonds for example have a predictable interest rate for at least 20 years, all the way up to 30 years. When you buy this type of bond, you know the rate you’ll get for quite a long time.
I’ve never bought any, because the last time I checked on TreasuryDirect, the annual interest rate for one is 0.10%.
Another reason I don’t like them, like I do bond funds, is that if you buy some EE bonds and decide in 2 years to cash out, you lose the last 3 months of interest accrued.
I bonds are pretty similar to EE bonds. They differ in that I bonds are inflation protected bonds, good for recent times during COVID when the economy is unstable.
EE bonds are more suitable for low inflation periods, because they’re not inflation protected like I bonds.
Again, you can adjust your bond buying goals every year or few years by going back and forth from EE bonds and I bonds based on how the market outlook is.
Time for some definitions
In this section, I want to briefly lay out some key words you’ll need to know and understand when investing in bonds.
What I did below was research the exact definition of the word, and then break it down into a cleaner definition that I’d understand. I hope this helps you too.
This is to get you going, I would recommend you do a bit more research on each key word that you don’t understand. Each word can be broken down even further and get pretty complex.
Bond Yield: The money you earn from the bond you buy.
Bond Discount: It’s the discounted value at which you buy the bond, compared to what it will be at maturity. The maturity value is often an even $1,000, and your bond discount might be something like $985. The difference is what you earn over time.
Coupon rate: Usually shown as a percentage, it’s the amount of interest the bond pays annually. If you buy a $1,000 bond with a 4% coupon rate, you’d earn $40 in interest per year.
Bond anticipation note: Short-term “notes” that are issued before a bigger future bond is issued. Usually issued by a state or municipal, to fund a new project.
Callable Bond: Some bonds have pretty high interest rate, like callable bonds. The issuer of such bond want’s to attract investors, but also be able to “call back” all their bonds and end the contract early, incase interest rates drop, and they can find funding cheaper elsewhere.
Bond default: This is when the bond you bought, stops making payments. This failure to repay the bond owners makes the bond “default”. In comparison to other assets, a business that defaults go into “bankruptcy” and a house that can’t have it’s mortgage paid anymore is “foreclosed”. All are essentially defaulted on.
What is a bond fund?
Still confused about bonds? It’s totally normal, I was both confused yet curious about buying my first batch of bonds back in 2008.
This was pre YouTube days, so I was just scouring the internet to figure out everything I needed to know about bonds, so I could invest comfortably.
I did end up buying 2 different bonds issued by private companies. I stopped there because I discovered bond funds shortly after.
If buying individual bonds is a tedious and confusing task for you, bond funds might be your best bet to still invest and diversify your portfolio.
Bond funds are basically the mutual funds of bonds.
Mutual funds, as we know, are funds that batch up many different stocks for a specific purpose. There can be tech mutual funds or mutual funds for banking.
Bond funds are the same thing, you can buy a bond fund that has a specific purpose, and be able to get a small piece of many different bonds. You could invest in a bond fund for commercial projects, or one for municipality-based projects.
You can pick a bond fund with a long term maturity date, or one with a short term.
Just like buying a mutual fund, you can see which “outfit” fits you best, and ride the wave. 2 different analogies, was that a bit confusing?
Vanguard has 2 different bond funds to choose from, I’d recommend you open both pages and read them in detail to get a good understanding of how they differ, what they offer, and the fees involved.
- Vanguard Total International Bond Index Fund Admiral Shares
- Vanguard Total Bond Market Index Fund Admiral Shares
What about Bond ETF vs. Bond fund?
Just like stock investing, an ETF is a fund that’s traded during open hours of the stock market, and a mutual fund is not.
Similarly, bond funds value can go up and down during trading hours, but your buy/sell request is only made at the end of the day.
If you’d like to have more flexibility to buy/sell during trading hours of 9:30 am to 4:00 pm, then you might want to consider getting a Bond ETF.
You can review over 423 ETFs traded in the U.S. market on this website.
What is a bond ladder?
Have you ever heard of a CD ladder? A bond ladder is pretty much the same thing, switching out the CD with bonds as the investment vehicle.
If you don’t know what a CD ladder is, let’s dig in, in the most simple way possible.
- You buy your first bond on January 1st, expiring a year from now
- You buy another bond on February 1st, expiring a year from that date
- You do this every month for the rest of the year.
- Next year, you’ll have bonds that expire every month for that whole year, giving you a return every month.
The easy way to make this ladder keep going is, if you don’t need that money, keep reinvesting the matured bond and profits from that bond into a new one. This means the ladder will keep going and growing over time.
Which Federal Agency oversees and regulates the buying and selling of bonds?
The Securities and Exchange Commission (SEC), a U.S. federal agency, is the one in charge of regulating buying & selling of bonds.
This regulation is extremely important because unlike a saving account, your investment is not FDIC insured. The SECs job is to oversee the securities exchange, and the people who issue, trade, and deal with the bonds.
I hope you found some great intro insights into Bonds and how you can get started buying some, to diversify your investments.
This post was meant to take you from no knowledge to having a general idea of how bonds work. In a future post, I will go a bit more advanced if you are interested, however in the 10+ years that I have been investing, I have mostly focused on Bond funds as an easy way to invest in bonds and diversify.
If you’d like to check out some interesting further reads, here are some of my favorite.
Great additional resources/reads:
- Mint’s post on how bonds work
- Official US Treasury website to buy bonds online
- Official Treasury Direct comparison of EE bonds and I bonds