Bonds...Investment Bonds

Similar to James Bond, investment bonds were very popular investment options through the 60s, 70s, 80s, 90s and even into the early 2000s. Then came along low interest rates and bonds fell out of favor with their returns near zero. With the Federal Reserve’s push to cool inflation by raising interest rates, it is a mistake to ignore bonds as a viable investment option.

Yet, many people steer clear of bonds as a boring option compared to a hot stock, or as a confusing option when compared to a high-yield savings account. Here is a quick summary of bond investing:

What is a Bond?

Bonds are the oldest form of investment. Unlike a share of stock, which gives you a tiny ownership stake in a company, a bond is a share of a loan to a government or company. Rather than you paying interest, you get to collect interest.

Bonds are known as fixed-income investments, as your return is a known quantity at the time of your investment. Bonds pay a set return each year, called a coupon, over a set period ending on a maturity date.

How are Bonds priced?

The price of that bond is based largely on the investment world’s perception of the safety of the issuer. Always check a bond’s credit ratings before you buy. A poor rating means the bond issuer, such as a corporation, is less likely to pay you back. This can be enticing because the issuer will likely offer you a higher interest rate. It also means they are more likely to default, which would mean you lose your investment.

The price of a bond moves in the opposite direction to interest rates. As rates rise, the value of older bonds with lower coupons declines. With today’s rising rates, you will see old bond investments losing value but new bond purchases with much better returns.

Are Short-Term Bonds better than Long-Term Bonds?

Yield, the fancy word for the money you earn, is currently higher for short-term Treasury bonds than longer-term Treasury bonds. Many investors will compare the yield on a 2-year Treasury bond with a 10-year Treasury bond. The difference in yields is known as the spread. Currently the spread is just .5% (5.1% yield for a 2-year compared to 4.6% for a 10-year).

The benefit of the short-term bond right now is that you get a higher yield now, but the downside of the short-term buy is that you could potentially lose out on higher returns if the interest rates drop below the current long-term rate when you are ready to reinvest. For example, you invest $5,000 in a 2 year Treasury bond today paying 5% rather than a 10 year Treasury bond paying 4.5% but the interest rate has dropped to 4% in two years. You gained a .5% annual return advantage for 2 years but lost out on a .5% annual return for 8 years.

One potential solution is to create a bond ladder by dividing your bond investment among bonds with progressively later maturity dates. Always keep in mind what your ultimate savings goals are and when you will need to access your investments to set your ladder.

Another option is to create diversity by purchasing a bond fund rather than individual bonds. A bond fund will pool together thousands of different bonds to provide diversification in time frame and reduce the risk of bond default.

How are Bonds Taxed?

If held in traditional retirement funds like a 401(k) or IRA, all bond investment gains are tax deferred until you withdraw funds.

If you are holding bonds in a non-retirement taxable investment account, the earnings are taxable but the actual tax can greatly vary:

Interest on corporate bonds is treated just like bank interest on your savings account at ordinary income rates.
The interest on Federal Treasury bonds are exempt from state taxes.
Municipal bond interest can be exempt from both state and local taxes if you buy the bond from your state of residence.

Where to Buy Bonds

You can buy Treasury bonds and almost any other bond through a brokerage house such as Charles Schwab or Vanguard. Government bonds can also be bought directly from TreasuryDirect (warning - it looks like a 1990s webpage).

Although it is much easier to buy bonds than it was 20 years ago when you had to call your broker, the bond purchase can be tricky as you are not buying directly from the issuer (unless purchasing on TreasuryDirect). Instead, you are buying from another investor or broker and the price of the bond may have shifted since the bond was initially issued. The advantage of using an online brokerage is that their sites recalculate the value of the bond with the change in market price and show you your final return before you hit submit purchase.