Today in Investing 101, we discuss the basics of bonds as helpful investments to round out a portfolio. To skip ahead to get started investing, check out our practical setup guide.
As a rule of thumb, most beginner investors understand that bonds are less risky. They also are often told that young people should allocate more to stocks than bonds. But beyond that, we want to highlight a few specific types of bonds that are likely in any bond ETF or Index Fund
For our Investing 101 series, we review common financial products including stocks bonds and real estate. Stay tuned for Investing 201, where we unpack common misconceptions and Investing 301 for investing strategies!
Intro to Bonds
Nearly all bonds work the same way. You as the bondholder get a pre-determined interest payment at certain times of a year. Most people focus on the “yield” of that bond which calculates the annual return of holding that bond.
While most everyday investors will not buy individual bonds, they will buy bond indices or ETFs which are always a mix of these bonds. Being able to understand the different bond types and terminologies is important for evaluating different bond exposures or better tailoring your bonds for your financial needs.
As with all investments, the more riskier the investment, the higher the reward! In this case, greater yield = greater risk.
Companies issue corporate bonds to fund their business. Depending on the company’s profits and amount of debt, that debt will either be rated (1) investment grade or (2) high yield.
- Investment Grade: Higher quality, lower risk bonds that typically come with lower interest payments to you, the bondholder
- High Yield: Lower quality, higher risk bonds that come with higher interest payments to the bondholder.
Municipal Bonds (Munis)
Munis are bonds issued by states, cities, local counties, etc. to fund government spending.
Notably, munis have tax benefits:
- Bondholders do not have to pay federal taxes on interest
- Muni bonds issued in the state or city where you live will be exempt from those state and local taxes.
- Muni bonds are difficult for beginner retail investors to buy, so instead, consider buying a muni ETF in your local city or state of residence. Especially in high tax cities like New York or San Francisco, the tax benefits can be substantial.
- We recommend buying munis in a traditional brokerage account over IRAs or 401ks because you cannot take full advantage of the tax perks in accounts that already have tax benefits!
Treasury bonds are backed by the government. US bonds are known as treasurities, but all governments offer bonds that any investor anywhere can buy. These bonds work in a similar way to corporate bonds and munis — the greater the risk of bankruptcy for that country, the higher the interest the bondholder gets.
Getting Started & Recommendations
We recommend starting an investment portfolio in a tax efficient way with an IRA or company 401(k). We go into detail below with steps to get you started ASAP.
Young Money Posts
- IRA Basics: How to Use an IRA and Start Investing Soon
- Investing Lessons and Mistakes for Your Stock Portfolio
- Investing 101: Basics of Stocks
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