How to invest in bonds? In our last article, we discussed the basics of what bonds are, why they exist and what you can do about it: buy them, own them, and collect interest payments.
If that was Accounting 101, today is Finance 101: how to invest in bonds, trading in bonds and thinking about bonds as part of a bond market, and not just as a loan with semi-annual interest payments.
The First Step: Purchasing a Bond
Unlike common stock or forex, individual bonds don’t trade on public exchanges. You have to buy them over the counter, and you’ll need a broker to do so. The most common way to purchase bonds is from within your brokerage account. For example, both TD Ameritrade and E-Trade allow you to shop and compare bonds, as do many other online brokers. You can even buy bonds directly from the U.S. government on TreasuryDirect.
Bond ETFs (exchange traded funds), on the other hand, do trade on stock exchanges, making them more liquid than traditional bonds. Because they’re made up of a number of bonds with different maturities, they can also pay coupon payments more often than twice a year — usually monthly. The funds are made up of a number of bonds, so the fund itself never matures, and the bonds within it can change often. For investors only familiar with stocks and ETFs, this can be a more familiar way to start trading bonds.
How to Invest in Bonds
To invest in bonds, you have two options. You can:
1) Buy bonds and hold them until they mature, collecting semi-annual interest payments along the way. You’re acting like a bank, lending money to a company that has a good use for it. All you’re doing is collecting interest instead of actively trading with your money. You’re happy to eventually get your money back in 2, 10, or 30 years. You’re focused on interest rates.
2) Buy bonds and try to sell them before maturity for a profit. In the meantime, you might collect some interest payments, but it’s not really about the interest payments for you. You’re more interested in the fluctuations of the bond’s price. You’re acting like a stockholder, watching the conditions in the overall bond market, reading corporate and economic reports to gauge the future of the company (or government) and generally trying to “buy low, sell high.” You’re focused on bond prices.
While it’s certainly possible to do both, as you’ll see below, bond pricing is complicated. Arguably, even more complicated than stock pricing.
How Bonds are Valued
The primary source of value of owning a bond is the interest rate. The interest rate an issuer pays is determined in part by creditworthiness: how likely it is to repay the bond at the maturity date. Investors should expect higher interest rates for riskier bonds: small, unproven companies or governments with unsteady cash flows. So, similar to a stockholder’s dividend, if you’re a bondholder for an extended period of time, you’ll receive interest payments from the issuer: a predictable, recurring source of value — and income.
The other source of value is in the fluctuating price of a bond. While the principal itself doesn’t change, the price paid on the market for the bond does. In certain circumstances, you can buy a bond at a lower price (say $900) and still expect to be repaid at the full-priced principal at maturity. However, it’s also possible for that $900 bond to lose more value if the issuer is at risk of defaulting, or actually does default. If the company or government isn’t going to have $1,000 to pay the bond at maturity, then you don’t want to be the one holding it — it’s worthless. You’ll sell it at whatever price you can get, which may be way below face value.
“That doesn’t seem that complicated. Buy low, sell high, right?”
Here’s where it gets a bit trickier. Interest rates and bond prices usually have an inverse relationship. That is, when the typical interest rate in the economy rises, the typical bond price tends to fall. This happens in part because the bond’s fixed interest rate (the amount that sets the interest payment you receive) has become less attractive relative to the overall bond market.
Think about it: if you could get larger regular interest payments elsewhere, it would make sense to sell your bond now, even at a slight discount, to move your money where there’s a better return. When this happens on a large enough scale, the demand for safe, low-interest-rate bonds falls, pushing their prices down.
In 2020, the opposite happened due to low interest rates. Volatility in the stock market pushed more money into the “safer” bond market. Bond prices shot up because everyone wanted in now. Meanwhile, yields fell to historic lows. Everyone wanted to lend companies money by buying their bonds, so companies didn’t have to pay much at all for the privilege of taking that money. While many think of bonds as safe, even boring investments, they’re subject to intense market forces, just like stocks and forex.
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