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The basics of bonds: What the average investor should know

Select explains what bonds are, how they work and where you can start investing in them.

Saul Gravy | Getty Images

Newbie investors are often overwhelmed with advice on how they should and shouldn't invest their money. But there are a few rules of investing that are tried and true, and one of them is to diversify your portfolio. In other words, don't put all your eggs in one basket.

Diversification essentially means spreading out your money between different assets and investment vehicles to lower the risk that you could lose everything if there's a financial crisis.

While you might automatically think about stocks when you begin to plan your investing strategy, bonds are another type of investment asset that help you achieve this diversification experts recommend. Plus, they typically carry less risk than stocks and can act as an inverse to stock performance.

Like many areas of investing, bonds can be complex, but today we're keeping it simple. Here's what the average investor should know.

The basics of bonds

Bonds = debt

In short, bonds are debt. It's not unusual for individuals to taking on debt from banks when they borrow money (in the form of a loan) to pay for a mortgage, car, higher education, etc.

But with bonds, think of the role as reversed. Individuals, or investors, lend money to corporations and governments who need the funds. We can call the corporations and governments the borrowers in this scenario.

Bonds pay interest

In exchange for lending money, investors are paid interest on bonds, similarly to how loan providers or credit card issuers charge consumers interest when they lend us money. Because bonds pay investors interest at regular intervals, they are often referred to as "fixed income investments" and can help offset any losses you may experience when you also put your money in stocks.

The annual interest rate bonds pay to investors between when the bond is issued and its date of maturity is known as a coupon payment, and it's usually paid out twice a year to investors.

With bonds, your investment is tied up until the maturity date. This is unlike with stocks, where you can buy and sell at any time. So, a 10-year bond has to be left untouched for 10 years. It's important you know what a bond's maturity date is before handing over your money.

Bonds are rated

Similar to how consumers have a credit score showing lenders their creditworthiness and how likely they are to pay back their debt, certain types of bonds also have credit ratings to show investors the likelihood that they'll get repaid on their investments.

The highest bond rating is AAA, on the S&P rating model. And any bond with a rating of C or below is considered higher risk of defaulting, which means investors could lose their investment.

You should also pay attention to interest rates and the rate of inflation when you go to purchase a bond. Two big risks to bonds are rising inflation and rising interest rates, the latter which can lead to bond prices falling. Both can result in bonds losing value.

There are different types of bonds

The main three types of bonds to know are corporate, municipal and Treasury bonds:

  1. Corporate bonds: As you might guess, these are bonds issued by corporations. Companies may decide to issue bonds in order to raise capital for things like research and development. Investing in corporate bonds means you'll have to pay taxes on the interest you collect, but these types of bonds typically offer higher yields than municipal bonds.
  2. Municipal bonds: Municipal bonds are issued by local (a city or town) and state governments that are looking to raise money for public projects, like infrastructure, parks or hospitals. Investing in municipal bonds means you don't have to pay taxes on the interest you earn.
  3. Treasury bonds: Commonly referred to as T-bonds, these are bonds issued by the federal government and thus considered low risk. In return, the interest rates are lower than corporate bonds. Investing in Treasury bonds means you'll have to pay federal taxes on your earnings, but not state or local. They can also be a smart buy when there is an inflation surge.

Where to buy bonds

Investors buy bonds from brokers or, in the case of U.S. Treasury bonds, directly from the government. Some of the big brokerage firms like E*TRADE, Charles Schwab and Fidelity specialize in bond investing and have tens of thousands of bonds available to investors.

In addition to purchasing bonds directly, you can also invest in a bond fund. Bond funds give you access to various types of bonds so you can invest in a mix.

When you sign up for a robo-advisor, you'll take a survey to assess your risk. Then the service's algorithm will recommend the best portfolio for your financial needs, which will often include a mix of stocks and bonds. Select reviewed dozens of robo-advisors and our top pick, Betterment, and the runner-up, Wealthfront, both offer a mix of stocks and bonds in their portfolios.

When shopping around for a broker, consider cross-referencing BrokerCheck, which can be a helpful resource to make sure a broker is credible.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.
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