Bond investing can provide you with a fixed, steady income. This is a great investment option for retirees and those who want to retire early and want a predictable income. Investing in bonds carries some undeniable advantages. First, they’re considered safe investments compared to stocks because their value is less volatile.

This makes them an excellent option for diversifying your portfolio. They help stabilize your investment portfolio by reducing the financial risk when the stock market fluctuates.

What are bonds?

In simple terms, a bond is a loan you make to a corporation or government as an investor. In return for lending them money, they agree to pay you interest payments, typically twice a year. The interest rate you will get is generally set when you buy the bond. Also, they agree to pay you back all your money on a specific date. 

These are some terms to keep in mind 

• Coupon: Refers to the interest rate paid. 

• Yield: An interest rate that accounts for a bond’s fluctuating value. 

• Face value: Also known as “par” value, this is the value of the bond when it is issued. If you paid $1000 for it, that is the face value. 

• Maturity: Refers to the length of time until you’ll get the bond’s face value back. 

How do bonds work?

When a corporation or government, also known as the issuer, needs to raise money, they issue bonds. These are like contracts with a maturity date and a fixed interest rate. The maturity date refers to when the contract ends, and you will get back all the money you initially invested. The interest rate determents the payment you will receive during the bond term. 

How to measure the risks of bonds?

Bond investors can lose money if the issuer defaults. Therefore, some organizations rate the quality of each bond by assigning a credit rating, so you can make a more knowledgeable decision about where to invest. As your teacher gave you As, Bs, and Cs when you were in school, some companies rate bonds. The most common designations are 

Highest quality: AAA to AA – meaning low-risk

Medium quality: A to BBB 

Low-quality: BB, B, CCC, CC to C – higher risk. 

This allows you to determine which bonds carrier the most risks. Remember, when you are buying bonds, you are lending your money, so just like banks check your credit report before lending you money, you should check the borrower rating to see the likelihood of you getting your money back. You can find more information about ratings here

When the bond rating is very high, you can expect a low-interest rate because it is low risk. The opposite is true when the rating is deficient. Bonds with low ratings typically pay a higher interest rate because of the increased risk involved.  

Types of bonds

Some companies issue bonds, but most of them are issued by governments. With few exceptions, government bonds are of higher- quality because they are generally stable. 

U.S. Treasuries

The treasury issues these bonds to raise money for government expenses and the nation’s bills. Therefore, as an investor, you lend money to the government for a set period in exchange for interest payments. Nevertheless, this investment is guaranteed by the full faith and credit of the U.S. government, so they are considered safe. 

• Treasury bills maturity of a year or less
• Treasury notes maturity of 1-10 years
• Treasury bonds maturity of greater than 10 years
• Treasury Inflation-Protected Securities (TIPS) 

You can buy these directly from TreasuryDirect.com. They can also be purchased through your brokerage. Federal tax is due each year on interest earned for these bonds, but there are no state or local taxes.

Government agency

These are issued by government-sponsored enterprises (GSEs) or U.S. government agencies such as Federal Home Loan Banks (FHLB)  and The Federal National Mortgage Association (FNMA or Fannie Mae). 

The U.S. treasury doesn’t guarantee agency bonds, but on some occasions, the government can step in to guarantee the payment to investors, like in the 2008 housing market crisis. During this time, Freddie MAC and Fannie MAE were at risk of default, but the government assisted them. 

 Their prices can rise or fall depending on interest rates. Typically, bond price drops as interest rate rises, and their price increase when interest rate drops. Therefore, there is some level of volatility involved.  

Municipal

Also known as munis, a local or state government issues these. Munis provide tax benefits. They are exempt from federal and local taxes, depending on your location. However, they tend to pay lower interest rates. If this is something you are considering, you may want to consider the tax benefits, as they can make a big difference in your overall return on your investment. Also, check the bond rating to determine the risks. 

Corporate

Like the other, you lend your money to a corporation, and they pay you interest during the bond’s life. Typically, they pay higher interest rates than other bonds, but there aren’t tax benefits. 

How to buy bonds?

You can buy them individually or buy a bond fund. Most individual bonds can be purchased directly from your broker account or TreasuryDirect.com. 

How are they taxed 

U.S. Treasury: Federal tax due each year on interest earned, but no state or local taxes exist.

Municipal: Depending on your location, they are free from federal and local taxes. For instance, you are usually exempt from state income tax if you buy muni bonds issued by the state where you file state taxes.

Corporate: The interest you earn from them is generally always taxable.

Government agency: Generally, interest income on agency bonds is subject to federal and state taxes. However, some are not taxable as those issued by the Federal Home Loan Bank and Federal Home Loan Bank of New York.