Bonds 101

What is a bond? How can I make money investing in them?

Next up on the risk tolerance ladder are bonds. With a savings account, you are lending money to a bank or major financial institution. With a bond, you are lending money to a government or corporation. Unlike a savings account, where you are able to withdraw your money at any time, when you invest in bonds you cannot access your money until a set amount of time passes (called the bond reaching maturity). Bonds are typically seen as either short term (under five years), intermediate term ( 5-10 years) or long term (10+ years). Typically, the longer you lend the money the higher the interest rate you get. For instance, if you bought a five year government bond today it would pay you .37% or $3.70 per year. If instead you bought a ten year government bond you would get 1.19% or $11.90 per year (based on investing $1000). This is because you are taking more risk in a long term bond than a short term bond. Think about lending a friend money for dinner. If they say they are going to pay you back at an ATM after dinner, or the next day when you go out for a drink you can feel fairly certain you are going to be paid back. If they plan to pay you back in five years you might not see that money. One of you might move, you might have a falling out, they might forget, a lot can go wrong so you are taking a bigger risk. When lending a government or business money the same principles apply. In the next six months, there is a good chance that they stay in good standing and are able to pay you back quickly. But in ten years there might be a war, they may go out of business, or various problems that could interfere with you being paid back.

You can invest in federal government bonds that support infrastructure and various programs in our country, or that protect the investor from inflation. You can also invest in municipal and state bonds, where your money is going directly to pay for projects that you support in your community. There is another neat government bond called a Treasury Inflation Protected Security (TIPS) where the federal government secures your investment against inflation.

Corporate bonds are one of the ways businesses raise capital for new projects. Each business that sells bonds gets a rating to help you figure out how secure the bond is from AAA (most secure) to D (least secure). Anything under a BB+ bond is considered a junk bond. The more secure the bond, the lower the interest rate they will give you. Junk bonds will often pay really high interest rates but you are betting that the company stays in business long enough to pay you back! In the United States, the only two companies with a AAA rating are Johnson and Johnson, and Microsoft.

I’m going to include another investment in this category called a certificate of deposit (CD). A CD is somewhere between a savings account and a bond. It is a loan to a bank or a financial institution just like a savings account, but like a bond the money is tied up for a fixed amount of time meaning you have less flexibility but will likely get a higher interest rate like a bond.

I currently have about 10% of my nest egg in bonds and am working to shift that downward to about 5%. I invest about half of this in intermediate term bonds from the federal government, and half in Treasury Inflation Protected Securities (TIPS).

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