How to Invest in Bonds

If you want to take the individual-bond route, that path is covered here, where you learn how to decipher bond listings you find in financial newspapers or online. Also learn about the purchasing process for treasuries (a different animal in that you can buy them directly from the government) and all other bonds.

Decide between individual bonds and bond funds

• Diversification is more difficult with individual bonds. You shouldn’t put your money into a small number of bonds of companies in the same industry or that mature at the same time. It’s difficult to cost-effectively build a diversified bond portfolio with individual issues, unless you have a substantial amount of money ($1 million) that you want to invest in bonds.
• Individual bonds cost you more money. If you purchase individual bonds through a broker, you’re going to pay a commission. In most cases, the commission cost is hidden—the broker quotes you a price for the bond that includes the commission. Even if you use a discount broker, these fees take a healthy bite out of your investment. The smaller the amount that you invest, the bigger the bite—on a $1,000 bond, the commission fee can equal several percent. Commissions take a smaller bite out of larger bonds—perhaps less than 0.5 percent if you use discount brokers.

On the other hand, investing in bonds through a fund is cost-effective. Great bond funds are yours for less than 0.5 percent per year in operating expenses. Selecting good bond funds isn’t hard.

• You’ve got better things to do with your time. Do you really want to research bonds and go bond shopping? Bonds are boring to most people! And bonds and the companies that stand behind them aren’t that simple to understand. For example, did you know that some bonds can be called before their maturity dates? Companies often call bonds (which means they repay the principal before maturity) to save money if interest rates drop significantly. After you purchase a bond, you need to do the same things that a good bond mutual fund portfolio manager needs to do, such as track the issuer’s creditworthiness and monitor other important financial developments.

Understanding bond prices

• Bond name: This column tells you who issued the bond. In this case, the issuer is a large utility company, Philadelphia Electric.
• Funny numbers after the company name: The first part of the numerical sequence here—7-1⁄8—refers to the original interest rate (7.125 percent) that this bond paid when it was issued. This interest rate is known as the coupon rate, which is a percent of the maturity value of the bond. The second part of the numbers—23—refers to the year that the bond matures (2023, in this case).
• Current yield: Divide the interest paid, 7.125, by the current price per bond, $93, to arrive at the current yield. In this case, it equals (rounded off) 7.7 percent.
• Volume: Volume indicates the number of bonds that traded on this day. In the case of PhilEl, 15 bonds were traded.
• Close: This shows the last price at which the bond traded. The last PhilEl bond price is $93.
• Change: The change indicates how this day’s close compares with the previous day’s close. In the example figure, the bond rose 2-1⁄8 points. Some bonds don’t trade all that often. Notice that some bonds were up and others were down on this particular day. The demand of new buyers and the supply of interested sellers influence the price movement of a given bond.

Sample bond listings

In addition to the direction of overall interest rates, changes in the financial health of the issuing entity that stands behind the bond strongly affect the price of an individual bond.

Purchasing treasuries

You may also purchase and hold Treasury bonds through brokerage firms and mutual funds. Brokers typically charge a flat fee for buying a Treasury bond. Buying treasuries through a brokerage account makes sense if you hold other securities through the brokerage account and you like the ability to quickly sell a Treasury bond that you hold. Selling Treasury bonds held through Treasury Direct requires you to transfer the bonds to a broker.

The advantage of a fund that invests in treasuries is that it typically holds treasuries of differing maturities, thus offering diversification. You can generally buy and sell no-load (commission-free) Treasury bond mutual funds easily and without fees. Funds, however, do charge an ongoing management fee.

How to shop for other individual bonds

• Don’t buy through salespeople. Brokerage firms that employ representatives on commission are in the sales business. Many of the worst bond-investing disasters have befallen customers of such brokerage firms. Your best bet is to purchase individual bonds through discount brokers.
• Don’t be suckered into high yields—buy quality. Yes, junk bonds pay higher yields, but they also have a much higher chance of default. Nothing personal, but you’re not going to do as good a job as a professional money manager at spotting problems and red flags. Stick with highly rated bonds so you don’t have to worry about and suffer through these consequences. The 2020 COVID-19 financial market meltdown clobbered lower-rated bonds.

Did you know what a subprime mortgage was before 2007, when stories of rising defaults were all over the news? Subprime mortgages are mortgage loans made to borrowers with lower credit ratings who pay higher interest rates because of their higher risk of default.

• Understand that bonds may be called early. Many bonds, especially corporate bonds, can legally be called before maturity. In this case, the bond issuer pays you back early because it doesn’t need to borrow as much money or because interest rates have fallen and the borrower wants to reissue new bonds at a lower interest rate. Be especially careful about purchasing bonds that were issued at higher interest rates than those that currently prevail. Borrowers pay off such bonds first.

Of the money that you want to invest in bonds, don’t put more than 5 percent into any one bond; that means you need to hold at least 20 bonds. Diversification requires a good amount to invest, given the size of most bonds and because trading fees erode your investment balance if you invest too little. If you can’t achieve this level of diversification, use a bond mutual fund or exchange-traded fund.

• Shop around. Just like when you buy a car, shop around for good prices on the bonds that you have in mind. The hard part is doing an apples-to-apples comparison because different brokers may not offer the same exact bonds. Remember that the two biggest determinants of what a bond should yield are its maturity date and its credit rating.

Unless you invest in boring, simple-to-understand bonds such as treasuries, you’re better off investing in bonds via the best bond mutual funds. One exception is if you absolutely, positively must receive your principal back on a certain date. Because bond funds don’t mature, individual bonds with the correct maturity for you may best suit your needs. Consider treasuries because they carry such a low default risk. Otherwise, you need a lot of time, money, and patience to invest well in individual bonds.