There are two primary ways to invest in companies—stocks and bonds. These are excellent ways to protect your funds, so you may want to put parts of your portfolio into bonds because they are safer than stocks. Still, it’s important to remember that bonds also come with risks. As you are loaning money to a company so they can pay their debt obligations when you purchase a bond, you will want to ensure the company has a good history of paying its debts.
Before purchasing bonds, you may want to research widely and know as much as possible before choosing one. This article will give you the basics of bonds so you can make an informed decision when diversifying your portfolio.
WHAT TO KNOW WHEN BUYING BONDS
Bonds often need more upfront money than stocks. As an investor, you can put down a small amount of cash to purchase stocks. Most bonds begin at $1,000, though there are ways to bypass these upfront costs.
First, it is important to know where you can buy bonds. There are multiple sources and they offer different things. You may buy bonds from a broker, an exchange-traded fund, or right from the U.S. government. Here is more information on each of these options.
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A BROKER
Most brokers offer both stocks and bonds. You may also buy bonds from other investors who are selling theirs. If you would like a discount on the initial cost of your bonds, you can buy them in an initial bond offering straight from the underwriting bank.
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EXCHANGE-TRADED FUND (ETF)
An ETF is excellent if you would like to purchase bonds that are associated with different companies. These bonds may have different term lengths that run from the short to long term. As an ETF allows you to purchase bonds without having to put down a minimum of $1,000. You can diversify your portfolio and get the opportunity to understand more about various markets and industries that you would have not otherwise been able to do without offering a lot of upfront money.
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GOVERNMENT
If you want to avoid fees from a broker or some other professional, you can buy bonds right from the federal government. More information about buying bonds can be found at treasurydirect.gov. The upfront costs for bonds can be higher than stocks so saving money by not having to find a broker can make things easier.
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RESEARCH TO BE DONE BEFORE PURCHASING BONDS
After you have decided to buy bonds, you may want to evaluate them thoroughly as one bond can be very different from another. Adding these two steps to your search can help you find the bonds that will complement your portfolio.
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MAKE SURE THE COMPANY HAS A SOLID HISTORY OF PAYING ITS DEBTS
When you purchase a bond, you are loaning money to the company so you can get interest on a principal amount and a rate of return that will be fixed for a period of time. If a company does not have a good history of paying their debts, this could increase your chances of losing money.
To find out if your potential company pays their debts, you can check on the most popular rating systems — Standard & Poor’s (S&P), Fitch Group, and Moody’s. These quantify a company’s creditworthiness and have an easy-to-understand rating system. AAA is the highest rating and it goes down much the same as school grades. Companies with a AAA rating have a much higher likelihood of handling your money properly.
Another way to see if the company you are investing in is safe is to look at its company’s income statement. Focusing on the company’s operating income (rather than its net income) and its interest expense can give you a good idea if this company handles its debts well. These 10-K filings are usually available on publicly traded company’s websites and are always available on the Edgar database which is located on the U.S. Securities and Exchange Commission’s (SEC) site.
After you have secured the 10-K filing, you will want to evaluate the company’s history over a period of years by dividing the annual operating income by the interest expense.
The resulting numbers can give you a good indicator of how safe a company is for your investments.
- 4 or more. This means the company has an excellent history of paying its debts.
- 2.5 to 4. The company will more than likely pay its debts, but those at the lower end of this range may need more research.
- 1 to 2.5. The company may have trouble honoring its commitment.
- Lower than 1. This company may not honor its debts. These companies should be avoided, especially if this rating is a trend over a number of years.
Overall, bonds that are supported by the federal government are the safest bonds to invest in. These are rated AAA and many investors deem the interest on these bonds to be the “risk-free rate”.
WHEN SHOULD YOU PURCHASE BONDS?
As bonds have an inverse relationship with the economy, it is hard to determine the best time to buy them. After the interest rate for a bond is set, trading begins in the debt market. The shifts in the interest rates within the debt market determine the bond’s price.
Bonds prices go down as the economy soars because interest rates rise. With this in mind, purchasing a bond when its price is low (or when the economy is high) may seem like a good idea, but this inverse relationship can make the actual value of these bonds tricky to figure out.
To avoid the uncertainty of your bond’s pricing, you may want to employ a “ladder” system. To do this you would buy many bonds that mature at different times over a span of years. Like laddering your certificates of deposit when saving for the future, laddering your bonds allows you to reinvest your principal amount as each bond reaches its maturity date. This allows you to lower the risks associated with the fluctuating interest rates as you have multiple bonds maturing at different times.
While building a ladder is highly recommended, bonds are often sold in $1,000 increments, which means you will need a decent amount of cash to create a bond ladder.
If you do not have the money to do this, you may want to try an exchange-traded fund. You have more flexibility with upfront costs and can still enjoy the benefits of a diversified portfolio.
