It is important to understand your choices and options when buying bonds.
What factors should you consider before buying bonds?
As with any security, your bond holdings should be tailored to your unique situation. Your financial professional can help you understand your choices and which options might suit you. Here is an introduction to some of the factors to consider when evaluating bonds.
Your income needs
If you're investing in bonds primarily for current income, a bond's coupon rate will set the amount of your payments. Think about whether you want to receive ongoing periodic income, or are willing to receive much of your return when the bond matures. Some bonds, such as zero-coupon bonds and U.S. savings bonds, pay interest only when the bond is redeemed. Remember that even if you don't need the income to live on, interest from bonds may help moderate the volatility of your overall portfolio.
Your tax bracket
Tax considerations are especially important for some investors. Some bonds are tax-advantaged. If you're in a high tax bracket, a bond whose interest is generally not taxable by the federal government, such as most municipal bonds, may be a better choice even though the interest rate it pays is lower than a comparable taxable bond. U.S. Treasury securities are generally exempt from income taxes imposed by state and local governments. Also, you'll want to compare the tax you'll pay on bonds compared to what you'd owe in taxes on corporate dividends. Qualifying dividends from corporate stock are taxed at the lower capital gain rate of 20% interest from taxable bonds is taxed at ordinary income tax rates.
Your time horizon
If you're considering holding individual bonds rather than investing in a bond fund, you'll want to think about how long you intend to hold each one. With individual bonds, you can tailor your maturity dates to when you'll need the money for a specific goal, such as paying for college tuition. You also can sell the bond before it matures, but the price you receive for it may be more or less than the face value, which means you could lose part of your investment. Some bonds pay all interest at the end of the bond's term when the principal is repaid.
Also, it's important to know whether the bond is callable or not. If it is, the issuer can choose to redeem the bond before its maturity date, which means you might not get income for the full period you were counting on. To compensate you for that possibility, callable bonds typically pay a higher interest rate than non-callable bonds. Long-term bonds are especially likely to be callable before maturity.
A bond mutual fund has no specific time horizon, since the fund manager may buy and sell specific bonds at any given time.
When thinking about your time horizon, it's important to consider the impact of inflation. Over time, the inflation rate will affect the value of most bonds and the interest they pay. As prices rise, each dollar buys less and less. Inflation can erode the buying power of both a bond's fixed interest payments and of the principal that will be repaid when the bond matures. As a result, the value of the bond to other investors can drop over time. On the other hand, if deflation occurs, the buying power of your investment dollars is increased and your bond would therefore be more attractive to investors.
Of course, other factors can affect the price of your bond as well. However, because both the interest rate and the face value of the bond are fixed, inflation's impact over time on the value of a bond investment can be greater than on asset classes such as stocks, which generally have more potential to grow in value over time. To help fight inflation, some bonds are designed to adjust both the principal and interest payments automatically based on changes in the Consumer Price Index.
As with any type of investment, you'll want to think about diversification (i.e., not having all your eggs in one basket). Diversification doesn't guarantee a profit or ensure against a loss, but if you've invested in bonds from multiple issuers, a default by one of them won't wipe out your entire bond holdings. However, you have to make sure that you have enough money to provide that diversification. If you don't feel you can afford adequate diversification with individual bonds, you might explore a bond mutual fund, an ETF, or U.S. Treasury securities that are backed by the U.S. government as to the timely payment of principal and interest.
Also, even though information about individual bonds is more widely available to the individual investor, you may not want to spend the time and effort to research individual bonds.
Your comfort with volatility
Many investors are surprised to find out that even though the face value of a bond remains the same, its value in the marketplace goes up and down. The longer the maturity, the greater the potential changes in a bond's price. You'll need to think about your risk tolerance. Are you willing to accept greater risk for the higher interest rates of a lower-quality bond? Or would you be more comfortable with a lower rate offered by a highly-rated bond or a Treasury security? Is a longer-term bond with a high interest rate worth the greater fluctuations in price you'll experience, or would a shorter maturity with more stability be better? Your financial professional can help you plot your strategy for balancing return and volatility.
How can you buy bonds?
Bonds are typically bought through intermediaries such as a broker, who has access to both newly issued bonds and older bonds traded on the secondary market. Treasury securities also can be bought directly from the U.S. government through its TreasuryDirect program; a list of auction dates and results is available at www.treasurydirect.gov.