Most investors focus their money on the stock market, but there is another way to make money the Wall Street way — by investing in bonds.
Bonds are similar to borrowing money, only the investor is the lender and the government or corporations are taking out the loan.
There are several types of bonds that have different outcomes in terms of how you can make money.
We’ll examine what bonds are, the different kinds of bonds, how you can make money off them and how to invest.
What Are Bonds?
Just like we stated, bonds are a bank’s or a corporation’s way of borrowing money.
Basically, when you purchase a bond, you are loaning the value of the bond to a bank for a set time. The borrower promises to make regular interest rate payments for that set time.
When the duration of the bond comes due, the borrower will pay the value of the bond back to you.
So you make interest off the bond and collect your initial investment after the bond expires.
The way it works is if you buy a 10-year, $25,000 bond at 2% interest, you are loaning the borrower $25,000. That borrower is promising to pay you 2% interest every six months on that $25,000. After 10 years, the borrower pays you the $25,000 back.
However, a zero-coupon bond works a little differently. Zero-coupon bonds don’t pay any interest during its duration, but you buy it at a significant discount off the face value. You might find a $25,000 zero-coupon bond for $10,000. But, when the bond term expires, you still get the $25,000 face value back.
Knowing what bonds are is a key factor in knowing how to invest in bonds.
How Do I Make Money With Bonds?
One big advantage of investing in bonds is you get a return on the principal. When the bond term expires, the borrower is basically paying that principal.
The biggest way to make money off bonds is through the interest payments. You get regular interest payments based on the value and interest rate of the bond.
Now, it’s not likely that your return on a bond investment will be higher than that of stocks, but the income is pretty much guaranteed.
That said, there are some risks in investing in bonds.
Risks Associated With Bonds
Like with any investment, there comes a certain degree of risk when investing in bonds.
The biggest being interest rate fluctuations. When interest rates on bonds go up, the value of those bonds may go down. If you buy a 10-year bond at 2% one month and the same issuer sells the same bond at 3% the next month, you lose out on additional earnings.
You also have to remember when you buy a bond, you are basically locked into holding that bond for a fixed amount of time. That can be as little as three months or as long as 30 years.
There is also a credit risk. If the issuer of the bond you bought defaults on the obligation, you could lose those interest payments, getting your principal back or even both.
Don’t forget that your return on investment is generally lower than if you were to purchase stocks on the market.
Make sure you do your research on who is issuing the bond, the interest, the principal and whether you are willing to take the abovementioned risks associated with investing in bonds.
Different Types of Bonds
As with stocks and different companies, there are different kinds of bonds you can invest in. The three biggest types are corporate, municipal and Treasury:
- Corporate bonds: These are bonds companies use to raise money for capital expenses, operations and mergers and acquisitions. It’s like getting an IOU from a company but unlike buying stock, you have no ownership in who you buy the bond from.
- Municipal bonds: Cities, towns and states issue bonds to pay for public infrastructure like schools, roads and hospitals. One benefit to buying municipal bonds is the interest paid to you is tax-free.
- Treasury bonds: Just like companies and cities, the U.S. government also issues bonds. They are backed by the federal government, so there is generally no risk of not getting the principal back. However, the interest rates are generally much lower than either municipal or corporate bonds. That means your regular interest rate payments are lower.
- Bond funds: These are funds that invest in different bonds. Like an exchange-traded fund, bond funds allow an investor to buy into several different bonds. However, because they are typically managed by money managers, bond funds come with management fees and commissions that you have to pay for.
- Junk bonds: Bonds considered “junk” are called that for a reason. They come with very high yield, but also a very high risk. They are below investment grade and come with a high chance of default.
Make sure you pay attention to the credit rating of any bond you buy. AAA is the highest rating while either a C or D (depending on the rater) is the lowest.
If you know the different types, it can help in knowing how to invest in bonds.
How Can I Invest in Bonds?
First, you have to decide if investing in bonds is right for you. If your current portfolio consists of all stocks, bonds are a way to diversify and mitigate risk against stock market volatility.
If you are an investor who really hates losing money, bonds are another avenue to keep some money flowing into your portfolio.
Buying bonds is a little more difficult than buying stocks. Unlike buying a stock at the market, bonds are not publicly traded. You have to find a bond broker, with the exception of U.S. government bonds which you can buy directly from the federal government.
You can find bond transaction prices by researching the Financial Industry Regulatory Authority, which posts prices as the information becomes available.
Going through a broker is the best bet, but understand that doing so could mean paying a higher premium for the bonds you buy.
Now that you have an understanding of what bonds are, how you can make money, the risks associated and the different types, you are on your way to knowing how to invest in bonds.