How to Invest in Bonds

Investments come in all shapes and sizes, but stocks and bonds are often seen as the two major players. Stocks generally offer higher returns, but more risk. Bonds are usually the opposite. These are generally considered to be safer investments, and can bring stability to an otherwise risk-heavy investment portfolio. Learn how to invest in bonds in this guide. 

What is a bond?

A bond is a loan given to a corporation or government with the expectation of being paid back with interest over time. Bonds are essentially portions of debt issued by companies and governments and converted into tradable assets. By purchasing a bond, you’re lending money to whoever issued it. Interest rates tend to affect the bond price. In a rising-rates environment, existing bond prices typically fall, and vice versa.

The U.S. government, local municipalities, and corporations all issue bonds as a way of generating capital. The issuer is then expected to repay the bond at a later time, known as the maturity date. That’s on top of interest payments that may be doled out along the way. These interest payments when a bond matures represent your investment gains. From 1950 to 2022, bonds have had an average annual return of 5.5%, according to J.P. Morgan. 

Bonds vs stocks

Publicly traded companies sell stock shares to raise money for growth and expansion. When you buy a stock, you’re getting a fraction of the overall value of that company. That gives you an ownership position. Stocks are traded on exchanges like the Nasdaq and the New York Stock Exchange (NYSE). The goal is typically to sell your shares for more than you paid for them—and ultimately score a profit. Historically speaking, the average annual stock market return is about 10%.

Unlike bonds, stocks are considered high-risk investments. The stock market is volatile by design, and market conditions are constantly in flux. It’s nearly impossible to time the market and consistently predict which stocks will do well and which ones won’t.

6 types of bonds

Before we get into how to invest in bonds, let’s unpack the main types of bonds. Each has its own expected returns and levels of risk. In general, the more stable the issuer, the lower the risk. Higher risk usually translates to higher returns.

Treasury bonds

Treasury bonds are issued by the U.S. government. These federally backed bonds are the lowest risk on the spectrum of bond offerings. There are three main types of treasury bonds:

1. T-bonds

These mature every 20 or 30 years, making them ideal for long-term investing. Some investors  choose to keep a portion of their retirement savings in T-bonds to protect themselves from risk and unlock a steady stream of income when they’re no longer working. They pay interest every six months. As of February 2023, the interest rate is 3.875% for 20-year bonds and 3.625% for 30-year bonds.

2. Treasury bills

Also known as T-bills, these short-term government bonds can mature in:

• 4 weeks

• 8 weeks

• 13 weeks

• 17 weeks

• 26 weeks

• 52 weeks

T-bills are auctioned at a discount of their face value. Interest is paid when the bill matures.

3. Treasury notes

Like T-bonds, Treasury notes pay interest every six months until they mature. However, the purchase price can be more than, less than, or equal to the face value. The price depends on two factors:

• The yield to maturity: This is the annual rate of return.

• The interest rate: This is also known as the coupon rate.

Treasury notes can mature in the following increments:

• 2 years

• 3 years

• 5 years

• 7 years

• 10 years

As of February 2023, the yield on a 10-year treasury note is 3.5%.

U.S. savings bonds

These government bonds are structured a little differently than Treasury bonds. Interest is compounded semiannually. Every six months, the bond’s interest rate is applied to a new principal value — this is the sum of the prior principal plus the earned interest from the previous six months. As a result, the bond’s value grows. Savings bonds are available for as little as $25 and can take two different forms:

• Series EE bonds: Earn a fixed interest rate and are guaranteed to double in value in 20 years. The interest rate for Series EE bonds purchased through April 30, 2023 is 2.10%.

• Series I bonds: Have a rate that's a combination of a fixed rate and an inflation rate that’s calculated twice a year. The interest rate on a Series I bond can change every six months, but the U.S. Treasury guarantees that it will never fall below zero. Series I bonds purchased through April 30, 2023, are guaranteed to earn 6.89%.

Treasury inflation-protected securities (TIPS)

TIPS are a type of government bond that’s indexed to inflation, which means they have higher interest rates as inflation rises, and lower rates as inflation falls. TIPS pay a fixed interest rate every six months and are available in terms of 5, 10, or 30 years. The interest rate frequently changes but will never be less than 0.125%.

Floating rate notes (FRNs)

These notes pay interest at variable rates. That can make them attractive in an environment where interest rates are rising. FRNs mature in two years and pay interest four times a year.

Municipal bonds

Munis, which is shorthand for municipal bonds, are issued by states, cities, and municipalities. The capital they bring in can be used for all types of projects, from building schools to developing highways. In terms of risk, munis fall in between Treasuries and corporate bonds. 

One perk is that they’re exempt from federal and most state and local taxes. (Other bond gains are typically subject to capital gains tax.) As a result, they have a tax-equivalent yield. That means the yield depends on your tax bracket.

Corporate bonds

Corporate bonds are issued by companies. Interest rates are usually higher than government-backed bonds because they carry more risk. That’s why every corporate bond has a rating to help investors evaluate them. These ratings range from AAA-companies, which are the most financially secure, to D-rated companies. Corporate bonds with low ratings may indicate that they’re a credit risk.

Benefits of investing in bonds                     

One golden rule of investing is to diversify your portfolio. This just means holding a healthy combination of different investment types — and it’s all about mitigating risk. If all your money is tied up in one asset class, for example, you could be in for some serious losses if your investments underperform. Having other assets in the mix can provide balance and help offset those losses.

That’s where bonds can come in. Sprinkling these stable investments into your portfolio may help insulate your wealth. Bonds can also create a steady stream of safe income, which can come in handy during retirement.   

How to invest in bonds

There are a few ways you can get started with buying bonds: 

A broker

Bonds may be purchased on the primary market, which is when they’re bought directly from the issuer. Investment banks also pass bonds onto the secondary market, where investors can make trades with a brokerage account. 

Buying into bond funds is fairly straightforward. For individual bonds, prices and availability can vary widely from broker to broker. Supply and demand will influence how much you ultimately pay.

Bond Mutual Funds

Investing in a bond fund like an ETF, rather than individual bonds, is another option. It gives investors access to hundreds of thousands of different bonds all in one share — providing instant diversification. A fund manager will handle the technical stuff for you. 

The buy-in also tends to be lower. With Acorns Invest, you can invest in bond ETFs with as little as $5.

The U.S. government

If you’d rather not pay a broker fee, you can buy government bonds directly through TreasuryDirect.gov. Simply open an account to access federally backed bonds in electronic form.

When thinking about how to invest in bonds, understand that each type has its own pros and cons. The right ones for you will depend on your investment portfolio, financial goals, age, and risk tolerance. The end game is creating a well-diversified portfolio that will help you reach your long-term goals.