How Do I Buy Bonds?

T-Bills, Ginnie Mae's, junk bonds, munis...what are bonds, anyway? How do you buy them? And more importantly, why do you we want them?

The Short, Easy Answer:

Your investment account, wherever it is, will probably let you buy all sorts of bonds, from municipals to high-risk corporate bonds and beyond. But if you are like most investors, the reason you want bonds is to add a bit more stability to your stock portfolio, and you aren't looking to become a bond trader. If this is the case, you have an easy way out. Your standard online investment account will also give you access to mutual funds and index funds that do the heavy lifting for you. With these you can indirectly own an interest in a mix of funds chosen to meet the investment strategy of the fund. Use the tips in the How To Choose An Investment post to figure out which bond fund works best for your goals.

But one word of caution: bond fund management fees can be expensive and pay outs can affect your taxes if you are not in a retirement account. Look closely at the fund's details and consider ETF's to address these issues.

There's the short answer. But it's worth understanding what you are buying and why. For that, read on...

Why Should You Buy Bonds?

If you've read my earlier post on asset allocation, you will know that bonds make up an important share of just about any portfolio. Why? Because bonds are a contract to pay back money owed. That makes them, in general, that much more stable than stocks (which are essentially an invitation to share in the ups and downs of a company). Of course, loans made to financially unstable governments or companies are plenty risky (hence the term "junk bonds"), but if you are loaning to the U.S. government, you are probably going to get your money back.

This makes U.S. government and other highly-rated bonds a good way to create a little safety margin in your portfolio. Think of bonds as the ring of padding around a trampoline—it can't keep you from falling, but it can keep you from a painful exit when things go wrong.

There is one more feature of bonds makes them worth considering  for people who are taking income from there investments. If you are trying to collect regular income from your investments, the predictably interest payouts of bonds can be an asset. This feature comes with a warning, though—investors who want to use bonds for income need to take precautions to address potential tax increases.

Basics of Bonds: What are they anyway?

Simply put, bonds are the paper contract that goes with a loan. If you are investing in them, you are the lender, and the borrower owes you back the money that was borrowed—called the "face value" of a bond—at some specific time in the future (called the duration). And of course, if you've loaned out money, you will some sort of interest payments to make it worth your while—the annual interest on a bond is called the coupon. That's the simple explanation; from there it gets a little more complicated.

The bond market is full of people buying and selling these bonds from the original lenders. And those folks are making bets about whether the interest rates for loans in general will be going up or down. After all, if I can own a bond that pays the 5% interest rate that was in play last year or the one that pays me a 6% interest rate from this year, we know which one I will go for. For just this reason, bond prices go down as interest rates go up and vice versa. And there you have one of the great truisms of investing.