When you think of investing, stocks are usually the first thing that comes to mind. But there’s another investment option that can be a critical part of your investment portfolio: bonds.
Bonds are generally less risky than stocks and can be a valuable source of stability for investors. According to Morningstar data, the average annual return of bonds between 1926 and 2023 (after inflation) was 5.1%. By contrast, the average annual return on cash was just 0.4%.
Learning how to invest in bonds and understanding their role in your investment portfolio can help you develop a balanced financial strategy.
Learn more: How to start investing: A 6-step guide
Bonds are debt instruments, meaning you lend money to an institution, usually the government or a corporation, that needs to raise money for their projects. In return, the issuer agrees to pay you interest and repay the principal once the bond reaches its maturity date.
“When I’m teaching young adults about bonds, I like to use this phrase to help them remember: ‘When you buy a stock, you’re an owner. When you buy a bond, you’re a loaner,'” said Thomas Henske, a certified financial planner (CFP) with the Affluent Insurance Advisor. “Bonds have fixed payment schedules for interest and principal, which makes them less volatile than stocks, whose prices fluctuate with market performance,” said Henske.
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There are three main types of bonds:
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Corporate. A corporate bond is sold by a company that needs money to fund the building of a new warehouse or to launch a new research initiative. The company commits to paying interest on the bond’s principal and, once the bond matures, to repay the bond principal.
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Municipal. A municipal bond comes from states, counties, or cities. Municipalities sell bonds to raise money for projects like the construction of a new school. As with corporate bonds, the municipality agrees to pay interest and repay the principal once the bond matures.
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U.S. Treasury bonds. You can purchase U.S. Treasury bonds through the U.S. Department of the Treasury. They’re fully backed by the U.S. government, so they’re generally the safest bond option.
If you’re wondering how to invest in bonds, there are three approaches:
With U.S. Treasury bonds, you can buy them directly from the government at TreasuryDirect.gov.
With other bonds, including corporate or municipal bonds, you have to work with a bond broker. Most investment brokerages, including well-known names like Fidelity, Vanguard, and Charles Schwab, can help you buy and sell bonds.
Learn more: Robo-advisor: How to start investing right away
An ETF is a type of investment that pools in a variety of securities, providing you with more diversification. Bond ETFs invest in a range of bonds from a particular sector, such as municipal bonds or corporate bonds. They can be appealing because they can be bought and sold on the stock market, giving you more flexibility when accessing and selling.
You can invest in bond ETFs through most major brokerages.
Bonds can play an important role in any investor’s portfolio, providing stability.
“Bonds provide a ‘dampening function’ to the volatility of a total portfolio, meaning that the bond allocation keeps the peaks from being too high and the valleys from being too low,” said Ronnie Colvin, a CFP with Fractional Planning. “It helps an investor sleep better at night if they are risk averse.”
Although bonds are relatively safe, investing too much in bonds can hurt you over the long run.
“While bonds tend to be safer, especially government bonds, they do not offer enough yield to grow a portfolio like stocks do,” said Colvin.
How much your portfolio should be invested in bonds — its allocation — differs based on several factors, including your age and risk tolerance.
For example, someone in their 20s investing for their retirement may have only a small percentage of their portfolio in bonds to maximize their growth. By contrast, someone closer to retirement age will have a higher percentage of bonds.
There is no one-size-fits-all allocation that works for everyone.
“I have seen (mostly on social media) a common rule of thumb is to subtract your age from 100 to determine the percentage of your portfolio to invest in stocks,” said Henske. “For instance, a 25-year-old might allocate 75% to stocks and 25% to bonds. Again, this is just a rule of thumb that, while interesting to talk about, is never part of my advice to clients because there are too many other variables to think about.”
Instead, meet with a financial advisor to review your finances and goals to come up with a personalized bonds investment plan.
Learn more: What is a financial advisor, and what do they do?
Bonds are often regarded as a “safe” investment, but there’s still a chance of losing money. If the bond issuer defaults on the bond, they fail to repay the interest or principal, causing you to lose your investment. There’s also the risk of inflation eating away at your returns.
“A bond might guarantee the return of your principal, but its real value could decrease if inflation significantly outpaces the interest payments,” said Henske.
The price of bonds has an inverse relationship to interest rates. When national interest rates go down, bond prices, or the value the bond provides, increase, and vice versa. The Federal Reserve lowered rates in 2024, so the demand for bonds will likely increase in 2025.
How bond returns are taxed varies by the type of bond. For example, bond funds, such as bond ETFs, are usually taxed as ordinary income, while municipal bonds are usually exempt from federal taxes.
