If you have only internalized one piece of advice about investing, it is probably that you need to diversify your portfolio. Many pundits and advisors suggest that a certain percentage of your portfolio consist of bonds. Bonds are generally perceived as safer investments than stocks because they have more predictable (albeit lower) interest rates. Typical guidance is to increase the percentage of your portfolio consisting of bonds as you age to make your investments safer. However, despite the perception of bonds as safer investments, many folks lack a basic understanding about bonds. If you are not sure what bonds are or how they work, this brief primer is for you.
What are bonds, and how are they different from stocks?
Bonds are a way for government entities and corporations to borrow money from the general public. When you purchase a bond, you become a creditor of the issuing entity by loaning it money. The total amount of outstanding bonds issued by a company would be listed as a liability on the company’s balance sheet.
Meanwhile, stock represents part ownership of a company. For example, if a company has issued 4,000,000 total shares of stock, and you own 100,000 of those shares, you own 2.5% (i.e., 100,000 ÷ 4,000,000) of the company.
How do bonds work?
The face value of a bond is its issue price, which is the amount loaned to the company. The bond will pay an interest rate, known as the coupon rate, that is a percentage of its face value throughout the life of the bond. The interest is usually paid twice a year until the bond reaches maturity, when the bondholder receives the face value of the bond. Many investors seek bonds for the reliable interest payments and to counteract the volatility resulting from owning stocks in their portfolio. Government bonds also have favorable tax treatment, making them attractive investments despite typically paying lower interest rates.
For example, assume your local school board decides to build a new school. It issues multiple $1,000 bonds to raise the $100 million needed for the project. The bonds have a 6% coupon rate, paid semiannually, and will mature in twenty years. If you purchase one of the $1,000 bonds for its issue price, you pay $1,000 now, receive payments of $30 every six months (so $60 total each year, which is 6% of $1,000) for the next twenty years, and receive $1,000 twenty years later on the bond maturity date.
How are bonds taxed?
While you own a bond, you will generally pay taxes on the interest earned each year. In the above example, the $60 of annual interest received is usually taxable.
The “usually” caveat is important because the example above describes a municipal bond (issued by local or state government agencies) rather than a corporate bond (issued by corporations). Interest on municipal bonds (also known as “munis”) are exempt from federal taxation. Additionally, munis are typically (but not always!) tax-exempt in the state where issued.
Besides corporate bonds and municipal bonds, another major type of bonds refers to those issued by the federal government. Treasury bonds (called “T-bonds”) and United States savings bonds both fall into this category. When the federal government has an annual deficit, it makes up the shortfall by issuing bonds and other Treasury marketable securities. Federal bonds are subject to federal income tax but exempt from state and local income tax.
Government bonds are also seen as more reliable investments than corporate bonds. Bondholders will not be repaid if a corporation goes defunct; a school board or the federal government is much less likely to simply stop paying its debts than a private company.
Rather than paying the interest out periodically, the interest on United States savings bonds accumulates and is paid out at maturity (or upon redeeming the bond if it is cashed in prior to maturity). Holders of savings bonds can either pay taxes on the interest as it accumulates each year or wait until the lump-sum interest payment at maturity or redemption to pay the applicable taxes.
The United States Treasury currently issues two types of savings bonds: Series EE bonds and Series I bonds. EE bonds have a fixed interest rate over the life of the bond, while the interest rate on I bonds is reset twice a year. This makes the returns on EE bonds more predictable, while I bonds have the potential for a greater or lesser return depending on interest rate fluctuations.
There are potential tax advantages to using United States savings bonds for higher education expenses.
As with stocks or mutual funds, the difference between what you receive upon the sale, redemption, or maturity of a bond and what you initially paid for the bond is a capital gain to the extent that the difference is not due to accumulated interest, which is taxed separately as described above. If you purchase a bond for its face value, and receive the face value upon maturity, there will be no taxable gain because the difference between the amount realized (i.e., selling/redemption/maturity) and your basis (i.e., purchase price) is zero. Even if the gain is zero, though, it is good practice to report the sale on Form 8949 when you file your tax return to prevent the Internal Revenue Service from asking about the transaction later.
How do you buy and sell bonds?
You can purchase bonds in two ways: directly from the issuer (self-explanatory) or on the secondary market.
To purchase bonds on the secondary market, you need a personal brokerage account (such as Vanguard, Fidelity, or Schwab). If you are reading this you probably already have one. Log into your account, search from the available bond offerings, and purchase—the same way you do with stocks, mutual funds, and ETFs.
When buying bonds on the secondary market, you are purchasing them sometime after issuance. The purchase price will differ from the face value of the bond to reflect the coupon rate as compared to the coupon rate on new bonds being issued, as well as the time to maturity.
If you wish to sell bonds rather than holding them to maturity, you also do that on the secondary market through your brokerage. If you initially purchased them through your brokerage, the process is easy: log into your account, and sell them the same way you do with stocks, mutual funds, and ETFs. (Sound familiar?) If you wish to sell bonds that you purchased directly from the issuer, you will need to transfer them to your brokerage first, so contact your broker for the steps you need to take. You will be able to sell them once they are in your brokerage account.
Like with purchasing bonds on the secondary market, you will generally be selling bonds for more or less than their face value.
There is no secondary market for United States savings bonds. They can only be purchased or redeemed via TreasuryDirect.gov. Meanwhile, Treasury bonds are traded on secondary markets.
What if I want to invest in bonds, but am skittish about jumping in?
If you want to invest in bonds but are feeling hesitant about it, there is another option: Invest in a mutual fund or ETF that tracks the bond market index. You are not investing in bonds directly, but rather in a product that tracks the performance of bonds.
If you want a product that tracks the bond market as a whole, consider the Vanguard Total Bond Market Index Fund (VBTLX), Vanguard Total Bond Market ETF (BND), or similar products at your brokerage of choice. You can also be more specific with your targeting, such as focusing on tax-exempt munis or emerging markets overseas. Just look for mutual funds or ETFs in a “bond” asset class.
Can I stay away from bonds?
If you want to stay away from bonds entirely even though that flies in the face of everyone you know not being able to shut up about bonds, that is fine too. Portfolios consisting entirely of stocks and no bonds did just fine in the Trinity Study and subsequent updates. Just be sure you are doing so because of personal preference rather than a lack of knowledge. On the other hand, if you believe that loaning money to a government entity or corporation is safer than owning a small piece of a number of companies, bonds may be a worthwhile investment to provide peace of mind regarding your portfolio. Your personal finance journey is just that—personal. Go your own way, but make sure you know why you are on the chosen path.
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