Understanding bonds

If you're looking to diversify your portfolio with investments that offer a steady stream of income, then consider fixed income securities such as bonds. 

Definition of bonds.

When you invest in a bond, you are a company's lender and the bond is like a note of debt—a promise to pay back the money you've loaned, with interest. Cities, states, the federal government, government agencies, and corporations issue bonds to raise money for purposes such as building roads and improving schools or technology.


Take a closer look at the benefits and considerations.

There are four key features to fixed income securities that make them desirable to investors: diversification, capital preservation, income generation, and potentially favorable tax treatment. Each feature provides a unique set of benefits that vary depending upon the type of fixed income security.

Diversification, capital preservation, income generation, and tax exemptions for U.S. expatriates

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    Diversification

    Fixed income securities, specifically high-credit-quality bonds, can help smooth out the highs and lows in a stock portfolio. That's because stock and bond prices have historically tended to move independently and with different magnitudes at any given time. However, diversifying with bonds does not ensure a profit and does not protect against a loss in a declining market.

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    Capital preservation

    Fixed income securities are ideal when preservation of capital is a priority. Specifically with bonds, principal is usually returned at a set maturity date. Higher-quality fixed income investments, like Treasuries, have the best potential for protecting principal. Though preserving capital is a key feature of fixed income securities, there is still the risk that the issuer of the bond will not make good on paying back the principal.

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    Income generation

    Fixed income securities are typically designed to provide a regular, predictable stream of interest payments on set dates. Keep in mind that there is a risk that the issuer will not make good on the promise to pay interest income.

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    Tax exemptions for U.S. expatriates

    Some fixed income securities have preferential tax treatment where coupon payments may be exempt from federal and state income taxes. Most debt securities are also not subject to U.S. estate tax for non-U.S. persons


    Keep in mind that potential tax advantages are generally factored into the price of any bond (and therefore its yield). Schwab recommends consulting a qualified tax advisor for specific individualized tax advice.


Common types of bonds.

Whether your goal is to diversify your investments, save for the future, receive dependable income, or minimize taxes, fixed income investments may have a place in your portfolio.

Schwab offers an extensive selection of fixed income investments, including individual bonds, Treasuries, and bond ETFs.

Treasuries

  • What are they?

    Treasuries are issued through the U.S. Department of the Treasury and are backed by the full faith and credit of the U.S. government. Because of their high credit rating, Treasuries are often the benchmark against which other debt securities are measured. 

    Examples of Treasuries include Treasury bills (t-bills), Treasury notes, and Treasury bonds.

  • Why consider Treasuries?

    Treasuries are considered one of the safest investments for protecting capital while also creating a predictable income stream. Additionally, Treasuries offer a wide range of maturity dates to choose from and are relatively easy to buy and sell, and interest payments are generally exempt from state and local income taxes.
     

Corporate bonds

  • What are they?

    Companies issue corporate bonds to raise capital for activities such as expanding operations, purchasing new equipment, or building new facilities. The issuing company is responsible for making interest payments and repaying the principal at maturity. Corporate bonds are senior to stock, so interest and principal must be paid before dividends are paid to stockholders.

  • Why consider corporate bonds?

    Corporate bonds typically have higher yields than those of similar fixed income investments, such as Treasuries. They can also provide a steady, predictable income, have a range of diversification choices, and are relatively easy to buy and sell in the secondary market.
     

Municipal bonds

  • What are they?

    States, cities, counties, and other local governments, as well as enterprises that serve a public purpose, such as universities, hospitals, and utilities, issue municipal bonds. They usually pay interest that is exempt from federal income taxes. Interest may also be exempt from state income taxes if an issuer in your home state issues the bond.

    There are two major categories of municipal bonds: general obligation (GO) bonds and revenue bonds.

  • Why consider municipal bonds?

    Municipal bonds can make an attractive investment option for conservative, income-oriented investors because the interest income is often exempt from federal, and potentially state, income taxes. Historically, municipalities exhibit repayment patterns that are stronger than those exhibited by corporate borrowers in the same credit rating bracket, meaning they tend to pay interest and principal on time, as scheduled.

Contact us to learn more about how these types of bonds can fit into your overall portfolio.

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What to know about trading bonds.

Interested in bonds but not sure where to start? These four steps can help you narrow your search. 

  • First, learn which types of bonds may be right for you by deciding your investment goals.
  • Second, consider how long your investing horizon is.
  • Third, determine the level of credit risk you're comfortable with.
  • Finally, determine how involved you want to be in managing your investments.

With that information in mind, you should be ready to start your search for the bonds right for you.

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Why invest in bonds with Schwab?

Schwab offers multiple ways to invest in bonds so you can choose the method right for you.

  • Tools and research for self-directed investors.

    Use Schwab BondSource® to screen more than 80,000 bonds from close to 200 dealers.1

  • Timely market analysis through expert insights.

    With timely analysis focused on what matters for investors, Schwab's insightful perspective and practical advice can help you make better investment decisions.

  • Dedicated specialists for complex needs.

    If you have complex needs and require guidance on fixed income strategies, you can get help from our dedicated team of fixed income specialists.


Common questions

Whether you plan to build your own fixed income portfolio or have it professionally constructed, understanding the steps involved can help you feel more informed moving forward.

  1. Define a goal: Start by clarifying your reasons for adding fixed income to your portfolio: Is it to help preserve capital, diversify your portfolio, or generate income?
  2. Choose an allocation: By combining bond investments with varying maturities and credit ratings, you can create fixed income portfolios that align with various levels of risk and are designed to meet different financial goals.
  3. Select ways to invest: Once you’ve defined your allocation, consider the ways in which you might invest. There are a variety of ways to invest in fixed income (e.g., individual bonds and CDs, bond mutual funds and ETFs, or managed accounts).

 

    When you buy a bond, the quoted yield considers the bond's annual interest rate and any difference between the purchase price and the amount you're expected to receive upon maturity or issuer call (the par or face value).

    Interest payments generally account for the bulk of a bond's return and are based on the bond's coupon (interest received on a bond) which is usually fixed for the life of the bond (although, some bonds have variable rates). The amount a bond pays is largely determined by the prevailing interest rate and factors specific to that bond.
     

    When a bond's price moves up or down, it still pays the same interest to the holder. Annual interest payments are calculated by multiplying the bond's face value by the coupon rate. Payments are generally made in semiannual installments, based on the dates set in the initial POS (Preliminary Offering Statement). You can find details for frequency and date of payment by clicking the description of the bond.

    Bond laddering is a strategy that can help minimize exposure to interest rate fluctuations. Instead of buying bonds that are scheduled to come due during the same year, you purchase bonds that mature at staggered future dates.

    The coupon is the annual interest rate the issuer promises to pay the holder each year, usually expressed as a percentage of par value (the amount the issuer originally borrowed and is obligated to pay back when the bond matures) of the security.

    The yield reflects the approximate measure of returns to the investor.

    Interest, credit, inflation and call risk:

    • Interest rate risk - When interest rates fall, bond prices rise. When interest rates rise, bond prices fall. You risk losing principal if you need money from a bond before it matures and you have to sell it when the price is low.
    • Credit risk - You risk that a bond's issuer will be unable to make interest payments or return your principal at maturity as promised.
    • Inflation risk - Inflation can cause risk for bonds and investments that pay a fixed amount of income. If prices rise due to inflation, but the interest payments you receive don’t change, you lose purchasing power.
    • Call risk - Some bonds are sold with a call provision that gives the issuer the right to redeem (call) the bond and return the principal before it matures. Bonds are more likely to be called when interest rates fall and the issuer can issue new bonds with a lower interest rate.

    An assessment of an issuer's ability to repay its debt, based on its history of borrowing, repayment, and other factors. Credit ratings are generally provided by an independent agency such as Standard & Poor's or Moody's Investors Service and are available through Schwab BondSource® on the Search Results and Order Verification pages. Ratings reflect a current assessment of the issuer's creditworthiness and do not guarantee future performance.

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