What You Should Know About Bonds

Investing in bonds is easier than you think. Like stocks, the key is to understand the investment first before you buy. So before we answer the question of “How do I invest in bonds?”, lets answer the question of “What are bonds”.

The primary purpose of a bond is to lend money to someone for a specific (fixed) term and in return, get a fixed rate of return. In real terms, when you buy a bond, you are lending your money to a corporation (this may be a company or a municpality) for a fixed term, and getting a coupon rate which is based on the original capital invested. The only tricky part involving bonds is how much of your money should be invested in bonds. That’s something we’ll take on another day. For now, lets focus on what bonds are and how to invest in them.

The main advantage to bonds is in their steady income stream. Unlike stocks, you know exactly what you are going to get, and when. For example, a bond that pays 3.5% with a 10 year term tells you that in 10 years, you will be getting your principal back, and, you’ll be getting 3.5% interest on that principal each and every year for 10 years.

A good strategy to use when investing in bonds is to look at your investment horizon. Do you have years or decades in front of you? Remember, the longer the term, the higher the coupon rate. Smart bond investors spread out their bond investments to cover both a short timeframe (less than 5 years), medium timeframe (5-10 years) and long term (more than 10 years). Remember, the longer the bond, the bigger the coupon rate, but the longer your money is tied up. By spreading the investments around, you can always count on a short term bond maturing right around the time you need the cash.

The best way to answer the question about how to invest in bonds is to look at a strategy of selling your bonds before it matures. When the interest rates go up, the price of an existing bond goes down – who wants your bond that is paying 3.5% when the interest rate is 4.5%? On the flip side, when interest rates go down, the bond price goes up – leaving you with upside trading potential.