Let's say your town asks you for a certain investment of money. In exchange, your town promises to pay you back that investment, plus interest, over a specified period of time. Bond funds take money from many different investors and pool it all together for a fund manager to handle. Usually this means the fund manager uses the money to buy a wide assortment of individual bonds. Investing in bond funds is even safer than owning individual bonds. Unlike stocks, most bonds aren't traded publicly, but rather trade over the counter , which means you must use a broker.
Treasury bonds, however, are an exception -- you can buy those directly from the U. The problem with this system is that, because bond transactions don't occur in a centralized location, investors have a harder time knowing whether they're getting a fair price. A broker, for example, might sell a certain bond at a premium meaning, above its face value. Stocks are investments in a company's future success.
When you invest in a company's stock, you profit along with them. The only person who can answer that question is you. Here are some scenarios to consider as you decide:. If you're the risk-averse type who truly can't bear the thought of losing money, bonds might be a more suitable investment for you than stocks.
If you're heavily invested in stocks, bonds are a good way to diversify your portfolio and protect yourself from market volatility. If you're near retirement or already retired, you may not have the time to ride out stock market downturns , in which case bonds are a safer place for your money. In fact, most people are advised to shift away from stocks and into bonds as they get older, and it's not terrible advice, provided you don't make the mistake of dumping your stocks completely in retirement.
A municipal bond is a debt issued by a state or municipality to fund public works. Like other bonds, investors lend money to the issuer for a predetermined period of time. The issuer promises to pay the investor interest over the term of the bond usually twice a year , and then return the principal back to the investor when the bond matures. A Treasury bond is debt issued by the U.
Technically speaking, every kind of debt issued by the federal government is a bond, but the U. Treasury defines the Treasury bond as the year note. Generally considered the safest investment in the world, U. Treasury securities of all lengths provide a nearly guaranteed source of income and hold their value in just about every economic environment.
A corporate bond is a debt instrument issued by a business to raise money. Unlike a stock offering, with which investors buy a stake in the company itself, a bond is a loan with a fixed term and an interest yield that investors will earn.
When it matures, or reaches the end of the term, the company repays the bond holder. With new issues, all buyers pay the same price. On the secondary market, there can be a markup on corporate and municipal bonds. You may also be charged commissions, transaction fees and contract fees on your bond-related transactions. When buying individual bonds, some investors want to manage their interest rate risk by spreading out the maturity dates for the bonds they hold.
You could spend it all on a single bond with a year maturity date, but your capital would be tied up for a decade—plenty can change in markets in ten years.
As each bond comes to maturity, you reinvest the principal in bonds with the longest term you chose at the outset—a 3-year maturity in this case. If interest rates are higher, you gain the advantage of better yields. Plus, you can stagger coupon payments to improve cash flow. When thinking about how to buy bonds for your investment portfolio, individual bonds offer several challenges.
In addition to the wide range of moving parts inherent in each bond, the primary market can be difficult to access for all but the wealthiest investors. The secondary market has less transparent pricing than primary issues, which makes it difficult for investors to know the true cost of individual bonds and how much markup is built into the cost. Bond mutual funds offer investors many of the benefits of individual bonds, with decreased risk.
Plus, buying mutual funds is a much simpler process. Like a stock mutual fund, bond mutual funds let you pool money with other investors to buy shares of a portfolio of bonds. Bond mutual funds may be actively or passively managed, funds typically follow a particular type of bond—corporate or municipal.
They tend to pursue a set maturity strategy, long term or short term. Bond mutual funds will come with management fees to compensate the fund managers for actively managing the bonds bought and sold within the fund. These minimums can differ between regular brokerage accounts and qualified accounts like IRAs.
You can invest in bonds by purchasing bond exchange traded funds ETFs. Like bond mutual funds, ETFs comprise baskets of bonds that follow a particular investment strategy.
Bond ETFs may also be passively or actively managed. ETF fees are typically lower than bond mutual fund fees. Besides cost, ETFs offer even greater liquidity. Shares of ETFs trade like stocks during regular market hours, rather than only once a day with mutual funds.
Like bond mutual funds, bond ETFs offer regular income payments. When trying to decide how to buy bonds, a bond mutual fund might be a better solution for investors who plan on holding the fund shares for an extended period of time. Buying bonds, whether individual bonds, bond mutual funds, or bond ETFs, provides diversification and reliable income for your investment portfolio. With all bond-related investments, you must do your due diligence: Research issuers, compare bond ratings , and if possible, consult with your investment professional to help guide your choices.
Unlike with large liquid stocks that trade millions of shares every day, many municipal bonds often only see only a few trades each month. The lack of transparency in the market just opens the door for bond brokers to charge small investors far more than they should be paying or pay them less, in the case of a small investor selling to a broker. Notably, this cost is hidden to the buyer. Below are the details for a more recent March trade of this same municipal bond.
This is not unique. In fact, it is the norm. Maybe this is enough to convince individual investors to stop buying bonds on their own. But there are additional reasons why individual investors should generally not be building bond portfolios on their own. An investor with bonds who needs to raise cash must determine which bond to sell, get quotes, evaluate whether the quotes are competitive, and then sell the bond.
Depending on what bond the investor sells, the resulting duration or credit quality of the portfolio may now be significantly different than it was before. Consider the real world. We have some clients who own a portfolio of bonds that they bought on their own or through another advisor. Occasionally, they need cash and ask for advice on which bond or bonds they should sell to raise cash.
To respond to this question with an answer better than what a monkey throwing darts might provide, we need to at least know the intended duration and the targeted credit quality of the bond portfolio. So maybe determining what individual bonds to sell is easier than we suggest.
Just ask a monkey to throw darts at a list of holdings. An investor, either an individual or a financial advisor, buys a portfolio of A or AA rated bonds.
This investor looks for available bonds with the highest yields, given the credit rating and the maturity. These bonds are purchased and the investor only takes further action if there is a significant credit rating change or a maturity. This common process assumes that all bonds of the same credit quality are the same.
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