The bond markets are a place often devoid of the retail or part time investor. It is often for professional investors, pension and hedge funds, and financial advisors, but that doesn't mean that part-time investors should steer clear of bonds. In fact, bonds play an increasingly important part in your portfolio as you age and, because of that, learning about them now makes good financial sense.

(For more, see: Top 6 Uses For Bonds)

Key Takeaways

  • Bonds are debt securities issued by corporations, governments, or other organizations and sold to investors.
  • Backing for bonds is typically the payment ability of the issuer to generate revenue, although physical assets may also be used as collateral.
  • Because corporate bonds are typically seen as riskier than government bonds, they usually have higher interest rates.
  • Bonds have different features than stocks and their prices tend to be less correlated, making bonds a good diversifier for investment portfolios.
  • Bonds also tend to pay regular and stable interest, making them well-suited for those on a fixed-income.

What Is a Bond?

When you purchase a stock, you're buying a microscopic stake in the company. It's yours and you get to share in the growth and also in the loss. A bond is a loan. When a company needs funds for any number of reasons, they may issue a bond to finance that loan. Much like a home mortgage, they ask for a certain amount of money for a fixed period of time. When that time is up, the company repays the bond in full. During that time the company pays the investor a set amount of interest, called the coupon, on set dates, often quarterly.

There are many types of bonds including government, corporate, municipal and mortgage bonds. Government bonds are generally the safest, while some corporate bonds are considered the most risky of the commonly known bond types.

Credit Ratings

Bonds are rated by popular agencies like Standard and Poor's, and Moody's. Each agency has slightly different ratings scales, but the highest rating is AAA with the lowest being C or D, depending on the agency. The top four ratings are considered safe or investment grade, while anything below BBB for S&P and Baa for Moody's is considered "high yield" or "junk" bonds.

Although larger institutions are often permitted to purchase only investment grade bonds, high yield or junk bonds have a place in an investor's portfolio as well, but may require more sophisticated guidance.

Pricing Bonds

Bonds are generally priced at a face value (also called par) of $1,000 per bond, but once the bond hits the open market, the asking price can be priced lower than the face value, called a discount, or higher, called premium. If a bond is priced at a premium, the investor will receive a lower coupon yield, because they paid more for the bond. If it's priced at a discount, the investor will receive a higher coupon yield, because they paid less than the face value.

Bond prices tend to be less volatile than stocks and they often responds more to interest rate changes than other market conditions. This is why investors looking for safety and income often prefer bonds over stocks as they get closer to retirement. A bond's duration is its price sensitivity to changes in interest rates - as interest rates rise bond prices fall, and vice-versa. Duration can be calculated on a single bond or for an entire portfolio of bonds.

How to Buy Bonds

Most bonds are still traded over the counter (OTC) through electronic markets. For individual investors, many brokers charge larger commissions for bonds, since the market isn't as liquid and still requires calling bond desks in many buy and sell scenarios. Other times, a broker-dealer may have certain bonds in their inventory and may sell to their investors directly from their inventory.

You can often purchase bonds through your broker's website or call with the bond's unique ID number, called the CUSIP number, to get a quote and place a "buy" or "sell" order.

Bonds and Taxes

Because bonds pay a steady interest stream, called the coupon, owners of bonds have to pay regular income taxes on the funds received. For this reason, bonds are best kept in a tax sheltered account, like an IRA, to gain tax advantages not present in a standard brokerage account.

If you purchased a bond at a discount, you'll be required to pay capital gains tax on the difference between the price you paid and the bond's par value, normally $1,000 per bond, but not until the bond matures and you receive the face value of the bond.

Issuers of bonds, on the other hand, such as corporations often receive favorable tax treatment on interest, which they can deduct from their taxes owed.

Local governments and municipalities may issue debt too, known as municipal bonds. These bonds are attractive to some investors as the interest payments to investors can be tax-free at the local, state, and/or federal level.

Alternatives

If you want the income earning power of a bond, but you don't have the funds or don't want to own individual bonds, consider a bond ETF or bond mutual funds. These are well diversified funds that give you exposure to many different bonds, and pay a monthly or quarterly dividend.

Because some bonds have a minimum purchase amount, smaller investors may find these products more appropriate for their smaller amount of capital, while remaining properly diversified.

The Bottom Line

Most investors, regardless of age, should have at least a small amount of their portfolio allocated to fixed income products like bonds. Bonds add safety and consistency to a portfolio. Although there is a risk that a company may default and cause a large loss, investment grade bonds rarely default, but along with safety comes a lower rate of return.

Before investing in bonds, always do further research into fixed income investing strategies.