To grow your individual retirement account (IRA), you choose where you want to put your money, and one of the options is investing in bonds. It may not be as tricky as the stock market, but it can be complicated without the right information. Learn more about what bonds are and how to invest today.
Investing in Bonds Inside Your IRA | Practical Tips to Learn
1. Learn the Basics of Bonds
Before you start investing in bonds, you need to know what they are.
Bonds are an instrument of debt that the government or a corporation initiates to generate capital. The creditor purchases the bond while the debtor is the issuer. Issued bonds are sold to investors who then pay the issuer of the bond upon purchase.
When you invest in bonds, you are essentially giving a loan to the other party. Because it is normal for people to hold on to their assets, to sweeten the deal, they offer to make periodic payments throughout the life of the loan usually twice annually.
Bonds come in the form of an electronic certificate. They contain the paid interest rate every year and the date of maturity. An initial investor purchases a bond in the main market. Then, an indefinite number of investors trade the bond through buying and selling in the secondary market. The secondary market also decides the market price of bond trading. Price setting includes the bond’s interest rate and demand, as well as the quality of credit.
The great thing about bonds is that you have many options to consider. Each one offers different benefits and considerations. Understanding the types of bonds can help you make informed investing decisions. The three primary types are:
- Corporate Bonds
- Municipal Bonds
- Government Bonds
You will learn more about them further down this article.
Investing in bonds for beginners requires setting up an account through a brokerage firm. The brokerage firm is associated with companies and governments that issue debts. They also have access markets for bonds trading in the secondary market.
2. Know Your Purpose for Investing in Bonds
Why do people invest in bonds? There many reasons:
- Diversity – There are many different types of bonds, which allow bond investors opportunities to create diversity among the bonds they purchase. Also, buying bonds, in addition to trading equities and investing in IRAs and mutual funds, helps those looking for investment income to diversify their portfolio and to grow their retirement nests.
- Principal Protection – Investors approaching certain financial goals, such as retirement, may elect to invest in bonds to generate income while protecting their investment. This is because the bond issuer will pay the interest and repay the principal amount.
- Tax Advantages – Some investors are seeking ways to minimize their tax burden. While not all bonds provide tax benefits, there are many that do on the state and/or federal level.
3. Understand the Challenges
There are no hard and fast rules for investing in bonds. It will vary according to how much you have to invest, what your long- and short-term financial goals are, and how much complexity you are comfortable with.
In turn, they often provide predictable and dependable results. This makes them an investment many people consider safe.
However, like other forms of investment, there are still possible challenges:
- Failure of the issuer to make agreed-upon interest or principal payments on the bond
- Inflation (since most bonds have fixed interest rates, this can have a larger impact than most investors realize, and it is one of the reasons it is important to work with someone who understands the market)
- Call complexities (in some cases, issuers will repay the bond before its maturity date, eliminating the interest payments you would have otherwise received)
- Illiquidity (when you invest in bonds, you are agreeing to give up access to your money for a certain period of time, so cashing out could be difficult)
The bottom line is to invest only as much as you are willing to lose. One rule of thumb for investing in bonds suggests you should subtract your age from 100 to determine the percentage of assets to invest.
For instance, at the age of 25, you want to have 75% of your assets in stocks and 25% in cash and bonds. When you are 65, on the other hand, you want to have 35% of your assets in stock and 65% of your assets in cash and bonds.
4. Know Their Credit Rating
Bonds are considered safe investments, but you must vet them before diving in. One tool you can use is the bond rating scores.
There are three primary agencies that rate bonds from best-quality bonds to worst. These are Fitch Ratings, Standard and Poor’s Global Ratings, and Moody’s Investors Service. Make sure you understand the rating scale of the agency as it can vary.
Usually, many of your high-yield bonds have BBB or Baa bond rating scores. They carry higher chances of default than some of the more attractive and reliable bonds but offer the promise of higher rewards if they pay off for investors.
If you want something simpler, consider short-term bonds. These include bonds with 5-year or fewer maturation rates.
5. Pay Attention to the Interest Rates
Most bond investments are fixed interest rates investments, but it does not mean investing in bonds provides you with immunity from market fluctuations.
If the interest rates rise during the term of your bond purchase, the value of the bond will fall. If the interest rates fall in value during your investment term, the value of the bond will increase.
There are various strategies investors use to shield themselves from market fluctuations. These include buying bonds with longer maturation terms at peak or near-peak interest rates, and buying shorter-maturation bonds when interest rates approach troughs.
6. Compare Bonds Purchases and Maturity
The par value of a bond is $1,000. Bond purchases are available in any multiples of $1,000, such as $5,000, $100,000, etc. Investors earn profit from bonds purchases through interest.
Meanwhile, the issuer receives proceeds from the sales. When the bond matures, the investor will receive the original investment. Sale of the bond before its date of maturity follows the current market price. It can be lower or higher than the par value.
7. Evaluate Bond Issuers
A bonds investment may consist of varying types of bond funds and bonds. For inclusion inside an IRA, an investor can choose from corporate bonds, US Treasury, municipal bonds, and bonds that generate high yields. Bond mutual funds and bond exchange-traded funds (ETFs) are among the choices for bond funds.
The bond issuer is the most important asset of a bond, however. The investor relies on them to return his or her money.
The main categories of bond issuers are the following:
- US Treasury Bonds
These are for safe investors. The US Treasury offers maximum security backed by the United States’ credit and absolute faith.
Because the United States has never defaulted on debt, investors have the assurance of getting their money back plus interest. From the government, the public can buy bonds with varying maturities.
The US government savings bonds also offer lower interest rates than corporate bonds. They have the added benefit of being tax-free from state and local taxes.
However, buy with caution and careful planning. These are not short-term bonds as most have maturity dates within 10 years or longer.
- Bonds from Other US Government Agencies
The agencies under this category are Fannie Mae and Ginnie Mae. Compared to treasury bonds, the yields are higher for these bonds. A number of these agencies offer mortgage-backed bonds, as well, which are more expensive.
- Foreign Government Bonds
This will depend on the nation offering the government bonds. Thus, these bonds can provide high or low yields. The investment will also depend on fluctuations in currency exchange rates.
- Municipal Government Bonds
Municipal bonds include benefits such as tax-free interest payments. In some situations, municipal bonds are exempt from state taxes.
However, the yields are lower because they are tax-exempt, and holding them inside an IRA will not result in an additional tax benefit. The good news is that it is a bond you can feel good about, especially if the money goes to support an endeavor you believe in.
- Corporation Bonds
Corporations issue corporate bonds, which provide the assurance of their ability to pay their obligations when it comes to debt. These can include physical assets, although this is not common.
There are greater challenges when it comes to corporate bonds compared to government bonds. Companies can encounter business-related difficulties, particularly during an economic crisis.
On the upside, they offer higher yields than government bonds. When investing in bonds, some financial advisors recommend these for investors in middle to higher tax brackets interested in a tax shelter, such as a rollover IRA.
- High-Yield Bonds
High-yield bonds are more appropriate for those who have a higher tolerance for risk. The bonds in this category pay more interest because the chances of default are higher.
However, because these bonds are non-investment-grade corporate bonds, they are more likely to increase in price with changes to a credit rating, which is investment-grade.
8. Select Your Investing Timeframe
The maturity dates of bonds are usually anywhere from a few years to 30 years. Investors must consider the time when they will access the invested funds and the bond’s maturity date.
9. Consider Other Bonds Investment Choices
Exchange-traded funds (Bond ETFs) and mutual funds are funds gathered from a pool of investors. These can be invested in different securities, including bonds.
The other term for these funds is investment securities. A combination of different bond portfolios composes bond funds.
Always consult with your financial advisor for any recommendations on bond mutual funds.
10. Exploit Your Tax Exemption
As your IRAs are, by law, tax-deferred, many investors tend to invest in bond funds with their IRA.
The income from bond funds is taxable, and those who generate this income with taxable accounts tend to get hit more on their after-tax returns.
On the other hand, your investment has a 4% yield and offers a 3% after-tax yield if you are in a 25% bracket.
Due to this, emerging market and high-yield bonds are well-suited to an IRA account.
11. Invest Your IRAs Wisely
To help maximize your after-tax returns, you must have a sound strategy when investing in bonds. Pay attention to your tax considerations.
However, your objectives, time, and tolerance are more important than your investment strategy.
When it comes to investing in bonds, the investor’s objectives must match the funds’ investment objectives. Recognizing and understanding your investment goals is difficult. It is, therefore, best to consult with a financial advisor during the bond selection process. You also need to conduct due diligence and observe the market changes at all times.
What are your considerations in investing in bonds inside your IRA? Share your thoughts in the comments section below.
Editor’s Note: This article was first published in December 2017, and has been updated for quality and relevancy.