The curious and enterprising investor can take advantage of a variety of securities to rake in the cash. They can also follow different kinds of investment strategies: While some traders look to make an immediate payoff and maybe even earn their living from trading, others simply want a stable, long-term investment that will help them save for retirement.
Investment grade bonds are one of those securities that make great long-term investments. In contrast to other kinds of traders, such as day traders looking for an immediate payoff, people who invest in bonds are usually looking for a long-term investment option that will yield a steady payoff over time.
How do investment bonds work? In summary, investment bonds are:
- Debt securities.
- A type of investment where the bondholder is essentially lending money to the issuer in exchange for interest payments.
- Looked on favorably by investors desiring a reliable, long-term income stream.
Learn everything you need to know about investment grade bonds to get started investing.
What Are Investment Grade Bonds?
A bond is like an IOU. It’s called a debt security because bonds are issued by borrowers, usually a company or a government, to raise money from investors. In exchange for lending the money for a certain amount of time, the bondholder receives interest payments. The bond’s issuer promises to pay a certain amount in interest over the life of the bond and to repay the principal once it ‘matures,’ or comes due after a pre-agreed period.
Investment grade bonds are one of the most important types of securities for individuals following an income investing philosophy, meaning they’re looking for relatively safe investments that will generate steady income.
A variety of bonds exist, including savings bonds, commercial bonds, and treasury bonds, which we’ll get into more in a minute.
What Are the Benefits of Bonds?
Bonds are common securities, in part because of their many benefits, including:
- A predictable income stream in the form of interest payments, usually issued twice a year.
- Earning back the entire principal invested if you hold on to it until it reaches maturity. Thus, bonds can help preserve capital.
- As part of a broader portfolio, the ability to help offset exposure to more volatile holdings.
There are also several reasons companies, governments, or municipalities might want to issue bonds. By issuing bonds, these entities can receive:
- Operating cash flow.
- Financing for their debt.
- Funding for capital investments.
Types of Bonds
Generally speaking, investors talk about several categories of bonds:
- Investment grade bonds have a high credit rating, indicating they come with less risk than high-yield bonds.
- Corporate bonds are debt issued by public and private corporations.
- High-yield bonds have lower credit ratings, meaning they present more risk for the holder. In exchange, they offer higher interest payments to the bondholder.
- Municipal bonds are issued by local government entities such as cities, counties, and states. Types of municipal bonds include:
- General obligation bonds, which are not secured by assets but backed by the "full faith and credit" of the issuer, which can typically raise revenue by taxing residents.
- Revenue bonds are backed by revenues from a particular source, such as highway project tolls. A nonrecourse revenue bond means the bondholders do not have a claim on the underlying revenue source if the revenue stream declines or ends.
- Conduit bonds, which governments issue on behalf of private entities with public interests, such as hospitals or universities. The issuer promises to pay the interest and the principal on this type of bond.
- U.S. Treasuries are bonds the U.S. Department of Treasury issues on behalf of the federal government. They are, therefore, usually considered popular and safe investments. Types of U.S. Treasuries include:
- Treasury Bills, which are short-term securities that typically mature within a few days to one year.
- Treasury Notes, which are longer-term and usually mature within 10 years.
- Treasury Bonds, which are also long-term and mature within 30 years, paying interest every six months.
- Treasury Inflation-Protected Securities, or TIPS, which are bonds and notes where the principal is adjusted based on changes in the Consumer Price Index. They are issued with maturities ranging from five to 30 years.
What Is the Difference Between Stocks and Bonds?
Stocks and bonds are two of the most common types of securities issued. But what’s the difference between them?
In short, bonds are debt, while stocks provide ownership stakes.
Stocks are essentially pieces of a company — when you buy them, you own a share of the company itself. When an entity issues a bond, it agrees to pay interest and pay back the principal. Bonds do not represent an ownership stake in the issuing entity.
What Are the Risks of Bonds?
So far we’ve discussed the benefits of buying investment bonds, but as with any security, it also comes with risks. The risks associated with bonds include:
- Credit risk/default risk: The bond issuer could default on the bond by failing to make timely interest or principal payments.
- Inflation risk: Inflation refers to the overall upward movement of prices, which reduces purchasing power. This is a risk associated with receiving a fixed interest rate. Depending on the rate of inflation, that fixed rate could be worth less down the road than you initially thought.
- Liquidity risk: This is a risk for investors looking to sell a bond before it reaches maturity. If investors can’t find buyers for the bond, they might be stuck with it when they want to sell.
- Interest rate risk: Rising interest rates make recently issued bonds more attractive to investors than older bonds because they yield a better fixed interest rate. If interest rates go up, it could be more difficult to sell a bond with a lower interest rate on the market. The seller could be forced to offer the bond at a discount.
- Call risk: A bond’s issuer might be able to retire the bond before it reaches its maturity date. This is a move issuers are more likely to make when interest rates decline, similar to how homeowners can refinance their mortgages to reap the benefits of lower interest rates. But that’s a risk for the bondholder.
Tips for Investing in Investment Grade Bonds
While bonds can be relatively safe investments, it’s important to do your research and have a strategy before you invest. Start by defining your investment objectives. Are you looking to save enough money to retire comfortably? Are you saving for a major goal such as buying a house or paying for your kids’ college education?
Once you’ve figured out your investment goals, you have a better sense of how to assess your risk profile. If you’re looking for a steady income stream and/or to save for a long-term goal, you’re likely looking for a relatively low-risk investment. Just like stocks or other kinds of securities, different kinds of bonds and bond funds have different risk profiles. Make sure you understand the risks before you invest, and ensure the risks align with your risk profile.
Once you’ve designed your investment strategy based on your goals and risk profile, you still need to do research before you invest. Read books and find information online about how to invest in bonds. Learn from experts, such as our team of RagingBull trainers. Before you buy a bond, learn about the company or entity you’re investing in. Check out the bond’s offering statement, which contains important information such as the bond’s yield and call schedule.
Finally, don’t just reach for the highest yield. Newbie bond investors are often tempted to simply look for the bonds with the highest interest payments, especially when interest rates are otherwise low. However, a high interest rate in these conditions likely means the bond represents a greater risk. Yield is just one of many factors an investor must consider, so do your research, and remember that a higher yield is almost always accompanied by higher risk.
Looking to learn more about investment bonds? RagingBull is a premier destination for investors looking to learn how to make more money. Our team of experts is standing by and ready to coach you through how to invest wisely. Sign up for a free training session with one of our team members on your own schedule to learn more.