A bond will pay you a fixed payment on specified dates over time and also return your premium to you once in matures. It’s a safe investment, especially if you’re putting your money in government bonds, if you want to start buying bonds it’s critical to decide how much to invest and then three subsequent questions below.
How Much Bond Investment Do You Need?
“Your age should equal the percent you have invested in bonds,” my father once told me. At age 22 I should have had 22% of my money in bonds based on his logic? Bonds are safe and I’ve come to believe that your situation determines your bond investing. If you’re 90 and have millions in the bank you might invest everything in stocks that you intend to leave to your grandchildren, conversely a 25 year old that just got a first mortgage and is paying for a wedding can’t afford to lose money and could have it all in bonds. There’s no need for complicate formulas, think about your life situation and how much of your money you want to keep safe.
Taxable or Tax Free?
You will in general get taxed on your bond returns if you buy them outside of a retirement account. Let’s say you invest $1,000 in a corporate bond that pays you $30 every six months for ten years. That $30 will be reported on your tax return as income and you’ll have to pay taxes on it. There are some bonds that are tax free, namely those issued by state and federal governments.
Unless you’re in the lowest tax bracket you should always buy tax free bonds outside of a retirement account. Bonds in your retirement account have any taxes deferred until retirement and the tax-ability is not a factor in decision making.
Short Term or Long Term?
You can get bonds in a variety of maturities, some that will last 30 years others that mature in 6 months or less. Short-term bonds are going to have prices that are less sensitive to movements in interest rates and the macro economy in general, while long- term bonds will fluctuate in price drastically when interest rates change.
Medium-term bonds of between 5-10 year maturity are a great compromise between these two alternatives. In general if you consider interest rates to be high when you’re bond shopping stick with a maturity nearer to ten years since they will be worth more when rates drop and similarly try sticking to near 5 year maturities when rates are low.
Bonds or Bond Funds?
In order to diversify a bond portfolio you should have at least ten different types of bonds in it. If each bond type has a minimum investment of $2,000 that requires a $20,000 total investment. Fortunately you can achieve that diversification by investing in a bond fund. $2,000 invested in a bond fund will be just as diversified as $20,000 in separate bonds. These funds are not only cheap and easy diversification but have the convenience of providing monthly income since they have many maturities wrapped up in the fund. This is typically better for most small investors in most situations.
To summarize, if you’re a small investor you’re better off investing in bond funds outside of your retirement account and medium term bonds of any variety in your retirement account.