No matter your age, bonds can be a smart addition to your investment portfolio. But if you're new to the bond market, you might struggle to navigate your options, which could put you at risk of losing money. Here are a few important tips to follow when you're buying bonds.
1. Always vet your issuers
Just as your credit record would be checked if you were to apply for a loan, so too should you check up on bond issuers' credit before deciding whether to invest in them. If you buy bonds from a company or municipality with shaky finances, you're taking on a greater risk that the issuer might default on its obligations. In other words, they might be unable or unwilling to make the agreed-upon interest payments or return your principal when they're supposed to.
That's where credit ratings come into play. There are three major bond ratings agencies that evaluate the creditworthiness of bond issuers: Standard & Poor's (S&P), Moody's, and Fitch.
The best ratings a bond can get are either an AAA by S&P or Fitch, or an Aaa by Moody's. The lower down the alphabet you get, the less creditworthy an issuer is, and the more likely it is that it will default on its obligations (which is the last thing you want). Keep in mind that bonds rated below BBB- by S&P and Fitch or Baa3 by Moody's are known as junk bonds. Junk bonds aren't considered investment grade, so you're best off staying away from them -- especially when you're first starting out.
2. Aim to minimize your taxes
The great thing about bonds is that barring a default, they provide a steady stream of predictable income by paying interest twice a year. The only catch is that you'll need to fork a percentage of that interest income over to the IRS -- that is, unless you invest in municipal bonds.
Also known as munis, municipal bonds are issued by states, cities, and counties, as opposed to corporations. The benefit of investing in muni bonds is that their interest is always exempt from federal taxes. And if you buy munis issued by your home state, you'll avoid state and local taxes as well.
Now one thing you should know is that corporate bonds tend to offer higher interest rates than comparably rated muni bonds. Therefore, you'll need to figure out whether it pays to score a higher amount of interest that you'll need to pay taxes on versus a lower amount of interest that's yours tax-free. For example, if your tax rate is 25%, buying a corporate bond paying 4% interest is effectively the same thing as buying a muni bond paying 3% interest. But if that corporate bond only offers 3.5% interest, you're better off with the muni bond.
3. Ladder your investments
When you buy bonds, you agree to lend the issuer a certain amount of money for a preset period of time. Now you do have the option to sell your bonds before they mature if you want or need to free up your cash, but in doing so, you're not guaranteed to recoup your full principal. For example, if the value of your bonds has declined since you made that investment, you'll lose money by selling them at a price that's lower than what you paid for them. That's why if you're going to buy a number of different bonds, it pays to ladder your investments so that they come due at varying times.
For example, if you have $12,000 to invest in bonds, you might put $4,000 into a bond maturing in five years, another $4,000 into a bond maturing in 10 years, and your last $4,000 into a bond maturing in 15 years. This way, you get access to your cash every five years, at which point you can reinvest it or use it as you please.
There are plenty of good reasons to put money into bonds, whether you're first starting out investing or are older and nearing retirement. Follow these tips, and with any luck, you'll choose some good ones for your portfolio.