On their face, bonds are simple: An investor loans money to a government or company and gets a guaranteed return with interest over a fixed period of time. But compared with what they know about stocks, many investors are less sure of which bonds to buy, or how to buy or evaluate them. Fortune spoke to three experts who walked us through some of the basics around bonds, but also shared a few lesser-known insights.
Another advantage: There’s a clear correlation between the interest rate, or “coupon,” of a bond, and the soundness of the borrower: The greater the perceived risk of default, the higher the rate. Richard Carter, vice president of fixed-income products at Fidelity, notes that bonds carry the additional benefit of being predictable. “You know when the coupon will be paid and when the bond will be paid back. That is eternal and appealing, especially for people older in life looking for income.”
Most bonds, like stocks, are highly liquid and easy to purchase. Investors can use brokerage platforms like Fidelity and Schwab to buy bonds on the primary or secondary market for low or no fees. They can also buy ETFs with very low fees that invest in a mix of bonds, while those chasing higher returns can consider a more actively managed fund.
Roth of Wealth Logic advises investors to buy T-bills of short and medium duration. Kathy Jones, chief fixed-income strategist at Schwab, endorses the popular “laddering” strategy, which entails buying bonds that mature at different times in order to insulate the investor against fluctuating rates.
Treasury bills also offer an advantage that dividend stocks don’t: Their yields are not subject to local or state income taxes. That makes them especially appealing to residents of high-tax states like New York and California. And income from municipal bonds, or “munis,” issued by cities and other local authorities, is often exempt from federal income tax as well. For those looking to calculate the value of these savings, Fidelity and others provide online calculators that let users see how the tax-advantaged yield compares with other fixed-income products.
While investors may balk at the thought of holding bonds from fiscal basket cases like Chicago or the state of Illinois, Jones says actual defaults are almost unheard-of, since government entities don’t go out of business. The bigger concern for investors is that advertised yields for munis can be misleading. As Roth explains, brokerages that sell munis can exploit a regulatory loophole that lets them tout too-good-to-be-true rates that reflect a portion of an investor’s initial capital when calculating a muni’s total yield. The upshot: A promised 6% annual return may turn out to be closer to 4%.
Finally, there are corporate bonds. Those looking for safe and secure returns can purchase bonds from companies rated BBB or higher, or a fund that includes them as part of a broader portfolio; those with more appetite for risk can invest in higher-yielding but lower-graded “junk” bonds.
Jones said this is an especially good time to consider company bonds since corporate profits have been especially strong. The cautious Roth, however, warns that companies can be prone to abrupt reversals of fortune. “I remember back when GM was ‘safe as America,’” he recalls, only to declare bankruptcy in 2009 during the financial crisis. He says investors should resist the temptation to chase extra yield: “Keep bonds the most boring part of your portfolio.”
Treasury bills: The ultimate safe investment, the popular 10-year Treasury typically delivers yields significantly above the inflation rate, while offering the additional advantage of being exempt from state and local income tax. An even better choice may be TIPS—Treasuries that offer a guaranteed rate above inflation.
Municipal bonds: “Munis” can offer a higher return than T-bills, while providing an especially sweet upside: They are not taxable at the state or federal level. But watch out for advertised rates from brokerages that can often exaggerate the real return (see main article).
