How to Buy Bonds

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If stocks are a form of ownership in a company, bonds are more of a pure loan. In effect, you lend money to a company or the government with the guarantee that you'll get it back over time, in exchange for getting paid interest. In that sense, buying bonds can provide a nice mix with stocks and other investments. And you can do it yourself, although it's smarter to work with a financial planner to be sure bonds fit with your particular investment strategy.

Things You'll Need

  • Financial advisors
  • Full-service brokers

Ask your financial adviser what types of bonds are available and who sells them. Companies issue corporate bonds to pay for various activities. These usually offer the highest rate of return (known as the yield). The federal government issues Treasury bonds, including Treasury bills (aka T-bills) and Treasury notes. These bonds don't yield as much as corporate bonds, but they are exempt from state and local taxes. Local governments issue municipal bonds to pay for community projects. These are free of federal taxes and may be exempt from other taxes.

Find out when the bond matures and how the interest payment is structured. A short-term bond matures in 3 years or less; an intermediate bond, in 5 to 12 years; a long-term bond, in 12 years or more. Interest can be paid monthly, quarterly or annually. You'll want to select a bond that works for your income needs; for example, if you have to make a tuition payment monthly, get a bond that pays interest monthly.

Pay close attention to a bond's rating to determine how safe that bond is. Agencies like Moody's or Standard and Poor's indicate how financially solid the bond's seller is. A higher rating generally means a secure bond. And the higher the rating, the lower the interest rate; junk bonds are risky but offer a much higher return (if the companies actually survive to pay back your loan). You may find a corporate bond with a lower rating and fairly good rate of return. The hard part is assessing how stable a company will be over the life of the bond so you can get your money back.

Know what "call" indicates. A bond's issuer, whether a company, municipality or government agency, retains the option to retire bonds early if it is in their interest to do so. This means that when interest rates go down, a bond issuer has the option of paying it off before the maturity date so that it can issue new bonds at a lower rate. You, as the investor, have your cash back, but you're faced with a lower rate of return if you reinvest the money.

Understand that bonds generate income through a series of prearranged payments to bondholders. But you can also make money because of interest-rate movement. For example, if you own a bond that yields 7 percent interest and interest rates go down, any new bonds being issued will pay less than the one you own. That makes your bond a more valuable commodity.

Be very aware of the risks involved. Interest-rate movement can also work against bonds. If interest rates go up, the bond you're holding becomes less valuable than new bonds that get issued. In addition to call provisions, companies can also go bankrupt and default on their bonds (think Enron), leaving bondholders with no interest or principal payments during the bankruptcy, and new bonds or a combination of stocks and bonds once the company exits bankruptcy protection.

Buy the bonds from a full-service broker (often charging a sizable commission--be sure to ask), from a discount broker (which costs less) or online through a site like etrade.com. Just pick the bonds you want and place an order. You can buy Treasury bonds directly from the federal government at regularly scheduled auctions. Contact a nearby Federal Reserve Bank for details or go online to www.publicdebt.treas.gov/ols/olshome.htm.

Consider bond funds. Many financial institutions offer bond funds that pool money from many investors to buy funds of differing types and maturities. The advantages are professional management and convenience. But remember you're still buying bonds, with all the same inherent risks.

Tips & Warnings

  • Shop and compare. Not all sellers may offer every available bond, nor will two sellers necessarily quote the same price for a bond. Waiting for the market to shift may also work to your advantage, but be aware that the same bond may not be available next week.
  • Diversify. As with stocks, it's better to mix up the sorts of bonds you own. Diversity of type, yield and maturity offers greater safety.
  • Issuers are developing all sorts of innovative bonds to meet specific needs. For instance, the federal government now offers an inflation-indexed Treasury bond designed to adjust to changing inflation rates.
  • If you're buying a small number of bonds at $1,000 each, or $5,000 to $10,000 for municipal bonds, the cost of the trade may be so high as to wipe out any yield you'd earn. Look carefully at the trade fee and the APR to make sure it's worth proceeding.

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