How to Buy Bonds: A 3-Step Guide
Wondering how to buy bonds? The bonds you choose (and in which proportions) will depend largely on your risk tolerance and goals. And you'll want to shop around since each broker often charges their own fees on top of the bond's price. Here are three steps to consider before buying bonds.
1. Determine your risk tolerance
Knowing what type of investor you are can help you determine how much of your total portfolio to allocate to bonds. While each individual investor's goals and objectives should determine the actual allocations, the percentages shown below should serve as a good starting point when considering how to invest in the bond market.
- Conservative investors seek current income and stability while being less concerned with growth: 50% bond allocation
- Moderately conservative investors seek current income and stability with only a modest need for portfolio growth: 50% bond allocation
- Moderate investors seek long-term growth but want less volatility than the overall stock market: 35% bond allocation
- Moderately aggressive investors seek long-term growth and can handle a fair amount of volatility: 15% bond allocation
- Aggressive investors seek long-term growth and are comfortable with high volatility in exchange for potentially higher returns: 0% bond allocation
2. Consider your goals
Once you decide on your bond allocation, think about your strategy behind investing in them. Your goals will play a key role in the types of bonds to include in your portfolio. (For reference, bonds with terms of less than four years are considered short-term; bonds with terms of 4 to 10 years are considered intermediate-term; and bonds with terms of more than 10 years are considered long-term.)
If your goal is to protect investment principal from losses, consider:
- Short-term U.S. Treasury bonds
- Short-term investment-grade corporate bonds
- Short-term investment-grade municipal bonds
If your goal is to diversify your portfolio and add income, consider:
- Short- and intermediate-term U.S. Treasury bonds
- Short- and intermediate-term agency bonds
- Short- and intermediate-term international developed-market bonds
- Short- and intermediate-term investment-grade corporate bonds
- Short- and intermediate-term investment-grade municipal bonds
- Mortgage-backed securities
If your goal is to maximize interest income, consider:
- Long-term Treasury bonds
- Long-term corporate bonds
- Long-term municipal bonds
- Preferred securities
- Emerging-market bonds
If your goal is to minimize taxes, consider:
- U.S. Treasury bonds
- Municipal bonds
3. Shop for the best prices
Finally, don't hesitate to comparison shop for bonds. "Many investors simply don't realize different firms charge different prices for the exact same bond," says Kathy Jones, managing director and chief fixed income strategist at the Schwab Center for Financial Research.
Bonds don't trade on centralized markets like stocks, which makes their true cost difficult—if not impossible—to ascertain. Instead, most are purchased "over the counter" through a brokerage firm that buys the bond on your behalf. The firm then tacks on a fee, or markup, that can range from a fraction of a percent to several percentage points, depending on factors such as bond liquidity and the firm executing the trade.
"Too many brokerages not only charge far too much but also conceal such costs from investors," Kathy says. So before you buy your next bond, ask yourself these important questions:
- What's the market price?
This will reflect the actual price it costs your broker to buy a bond from another dealer (which may include fees paid to the dealer). - What's the markup?
A markup refers to the difference between the market price of a bond and the price a broker-dealer charges to sell it. A markup is generally wrapped into the price—and may or may not be disclosed. - Are there additional fees?
In addition to markup, brokers may charge miscellaneous fees to cover administrative services, clearing fees, overhead, etc.—which they may or may not be required to disclose. - What's the accrued interest?
When you buy a bond between coupon payment dates, you'll owe the seller any accrued interest since the last payment date. This cost has nothing to do with your broker but does factor into the total cost. - What's the overall cost?
This will include all of the above: the market price plus any markup, additional fees, and accrued interest.
"Be wary of firms that fail to give you direct answers about their fees," Kathy advises. "They're probably being opaque for a reason."
Even seemingly small differences in markups can mean giving up hundreds, if not thousands, of dollars in total returns over time. It pays to shop around.