How To Buy Bonds: A Primer for New Investors (2023)

Learning how to buy bondsis an essential part of your education as an investor. A well-diversified investment portfolio should strike a balance between equities and fixed income, letting you ride out volatility while capturing growth along the way. In Canada, you can buy bonds through your brokerage account, or you can purchase bonds directly from the issuing government or corporation. Let’s take a closer look at the basics of buying bonds.

What are Bonds?

Bonds are similar to stocks, in that they are issued by corporations or governments to raise funds for business operations. However, in the case of bonds, you are lending money to a business or the government. A simple way to think of a bond is like a loan, but you are the lender—you give the issuer money and the issuer pays the investor interest and, eventually, the entirety of the principal balance.

Why Invest In Bonds?

Bondstend to offer a reliable cash flow, which makes them the good investment option for income investors. A well-diversified bond portfolio can provide predictable returns, with less volatility than equities and a better yield than money market funds. Even when interest rates are low, bond investing options like high-yield debt or emerging market bondscan meet an investor’s need for income, although with substantially more risk.

“The purpose of fixed-income investments is to adddiversificationto a portfolio,” says Rich Powers, Head of ETF Product Management at Vanguard. “If you look at the return of the U.S. stock market this year, stocks are down roughly 13%. U.S. investment-grade bonds are up a little more than 4.5%. That’s important because if an investor holds a balanced portfolio of stocks and bonds, that helps them have a less volatile investor experience.”

Types of Bonds

There are a variety of types of bonds available to Canadians. These are broken down by the entity that issues them. Here are a few of the main types of bonds.

Government Bonds:

These types of bonds are issued by the Canadian Federal Government and are one of the most safe investments you can make. Secured by the government, payment of the principal and interest are guaranteed. You will also receive interest payments twice per year and you can see government bonds at market value on any business day.

Provincial and Municipal bonds:

These types of bonds are issued by provincial or local governments to fundraise for projects specific to their community (for example, to build a new school or repair a road). They are considered very stable, but less so than government bonds.

Corporate Bonds

When a company wants to expand its operations, they may issue corporate bonds. When you buy one of these, you are essentially loaning money to a corporation and they pay you interest on the value of the bonds purchased. These bonds earn a fixed interest rate, usually paid out twice a year. When considering corporate bonds,you should understand the bond’s rating (investment-grade or non-investment grade/junk bonds), maturity (short-, medium- or long-term), interest rate (fixed or floating) and how the coupon (interest payment) is paid (regularly or zero-coupon). To complete your purchase, you’ll need a brokerage account that will cover your purchase price and any commissions your broker might charge on the acquisition. There are two types of corporate bonds: investment-grade and speculative-grade.

Investment-grade Corporate Bonds: These are bonds issued by companies that have a higher credit rating, making them a less risky investment.

Speculative-grade Corporate Bonds: These are issued by companies that are typically newer or in a more competitive sector, making them riskier investments. Since there is a higher chance of default, these bonds make up for the risk by paying out higher interest rates to investors.

Foreign bonds: This is a bond sold by a foreign country or company in their currency. The interest is computed in the currency of the country you bought it from.

Buying Individual Bonds

Buying individual bonds offers investors the ability to lock in a specific yield for a set period of time. This strategy offers stability, whereas the yield on a bond mutual fund or fixed-incomeexchange traded fund (ETF)fluctuates over time.

Keep in mind that when buying bonds directly from the government or a corporation, you will need to contact a broker in order to make a purchase, as these are not traded on the stock exchange like a bond ETF.

Your broker can be a financial institution, brokerage, or another licensed financial advisor. They can provide you a list of bonds available for purchase. After you pick one, they will make the purchase for you.

However, brokers are not free: they usually charge a flat rate commission to purchase bonds. With that in mind, it makes sense to make a purchase that is at least a few thousand dollars to keep your costs to a minimum.

Also, if you decide for some reason to sell the bonds you own before they mature, you will need to call your broker again to make a trade and pay commissions again.

Whether you’re exploring how to buy municipal bonds, corporate bonds or treasuries, the basics of buying an individual bond remain the same: You can purchase them as new issues or on the secondary market.

However, individual bonds offer several challenges. In addition to the wide range of moving parts inherent in each bond, the primary market can be difficult to access for all but the wealthiest investors. The secondary market has less transparent pricing than primary issues, which makes it difficult for investors to know the true cost of individual bonds and how much markup is built into the cost.

If individual bonds seem too complex for your level of investment savvy and you don’t want to use afinancial advisorfor guidance, you can explore two additional ways to add fixed-income instruments to your investments: bond mutual funds and bond ETFs.

Buying Bond Mutual Funds

Bond mutual fundsoffer investors many of the benefits of individual bonds, with decreased risk. Plus, buying mutual funds is a much simpler process.

“Some of the key features of bond mutual funds are the benefit of diversification and professional management,” says Powers. “With a bond mutual fund, investors get the benefit of fixed income professionals managing the money and being in a pooled fund where they’re not holding just ten individual bonds. They’re holding hundreds of bonds where the likelihood of one bond disproportionately impacting your results is much lower.”

Like a stock mutual fund, bond mutual funds let you pool money with other investors to buy shares of a portfolio of bonds. Bond mutual funds may be actively or passively managed, funds typically follow a particular type of bond—corporate or municipal. They tend to pursue a set maturity strategy, long term or short term.

Some of the benefits of bond mutual funds include:

• Liquidity:You can buy and sell shares of bond mutual funds as easily as buying shares of stock. Unlike stock, orders to buy mutual fund shares are executed once per day, after the market close.
• Dividend reinvestment:Funds make it easy to reinvest your income payment dividends back into the fund to keep building your investments.
• Regular income:As an alternative to reinvesting dividends, most bond funds give you the option to receive monthly payouts, providing a steady stream of cash for investors who want the income benefits of bonds.

Bond mutual funds will come with management fees to compensate the fund managers for actively managing the bonds bought and sold within the fund. This fee is expressed as an “expense ratio” and indicates the fees you’ll incur based on your investment each year. For example, a bond fund with an expense ratio of 1% will charge you $10 per year on your $1,000 investment.

Many bond mutual funds have minimum initial investments which you’ll want to note, too.

Buying Bond ETFs

You can invest in bonds by purchasing bondexchange traded funds (ETFs). Like bond mutual funds, ETFs comprise baskets of bonds that follow a particular investment strategy. Bond ETFs may also be passively or actively managed. ETF fees are typically lower than bond mutual fund fees.

“By and large, ETFs are very low cost, and investors can keep more of the returns for themselves instead of paying a manager’s fees as with a mutual fund,” says Powers. “For a newer investor or someone with less money to invest, the threshold of entry is just the NAV cost of the ETF instead of the initial investment minimums with many mutual funds.”

Besides cost, ETFs offer even greater liquidity. Shares of ETFs trade like stocks during regular market hours, rather than only once a day with mutual funds. Like bond mutual funds, bond ETFs offer regular income payments.

When trying to decide how to buy bonds, a bond mutual fund might be a better solution for investors who plan on holding the fund shares for an extended period of time. More active investors might prefer bond ETFs since there aren’t short-term redemption fees charged by many mutual funds to discourage excessive trading.

Other considerations when it comes to bonds

New issue bonds

Buying new issue bonds means you’re buying bonds on the primary market, or the first time they’re issued, similarly to buying stock in a company’sIPO. Investors acquire new issue bonds at what’s called the offering price.

Secondary Market Bonds

Bondholders often sell their bonds prior to maturity on the secondary market. If you’re interested in learning how to buy bonds that aren’t new issues, you can buy all the above types of bonds on the secondary market. Purchases are made via a brokerage, specialty bond brokers or public exchanges.

When buying bonds on the secondary market, you’ll need to do more research because pricing is less transparent. With new issues, all buyers pay the same price.On the secondary market, there can be a markup on corporate and municipal bonds. It’s also entirely possible to see the same bond offered by two different dealers at two different prices. You may also be charged commissions, transaction fees and contract fees on your bond-related transactions.

Bond Ladders

When buying individual bonds, some investors want to manage their interest rate risk by spreading out the maturity dates for the bonds they hold. This is referred to as “bond laddering.” Fixed-income investors use bond ladders to provide additional flexibility adjust their holdings to changing market conditions.

For example, you might have $15,000 to invest in bonds. You could spend it all on a single bond with a 10-year maturity date, but your capital would be tied up for a decade—plenty can change in markets in ten years. With a simple bond ladder, you would purchase three $5,000 bonds with staggered maturity dates: One year, two years and three years, for instance.

As each bond comes to maturity, you reinvest the principal in bonds with the longest term you chose at the outset—a 3-year maturity in this case. With this simple bond ladder, you would have $5,000 to reinvest each year. If interest rates are higher, you gain the advantage of better yields. If they’re lower, the ladder still includes maturities locked in at higher yields.Plus, you can stagger coupon payments to improve cash flow.

The Bottom Line

Buying bonds, whether individual bonds, bond mutual funds, or bond ETFs, provides diversification and reliable income for your investment portfolio. With all bond-related investments, you must do your due diligence: Research issuers, comparebond ratings, and if possible, consult with your investment professional to help guide your choices.