5 Things To Know Before Buying Individual Bonds

(MENAFN- Free Financial Advisor) Individual bonds can provide scheduled interest payments and a defined maturity date, but investors should examine purchase prices, credit ratings, call provisions, and taxes before buying – Shutterstock

A bond can promise regular interest payments and return your principal on a specific date. That's a pretty appealing arrangement, especially for investors who prefer fewer surprises in their portfolios. But individual bonds come with a catch: The payment schedule might look simple while the investment itself hides several moving parts.

Unlike a bond fund, an individual bond has a specific maturity date. You can choose when you want your money back, assuming the issuer meets its obligations. That control can make bonds useful for retirement planning, future expenses, and income strategies.

Still, buying the first bond advertising an attractive interest rate can lead to some unpleasant surprises. The coupon rate doesn't tell the whole story, and the price you pay can change your actual return. Here are five things worth knowing before handing your money to a government, municipality, or corporation.

1. The Interest Rate Isn't Your Actual Return

Bond advertisements love a nice, clean interest rate. A corporate bond might offer a 5% coupon, which sounds straightforward enough. Buy $10,000 worth, collect $500 annually, and eventually get your principal back.

Except that calculation assumes you purchase the bond at its face value. Individual bonds trade at different prices. A bond with a $1,000 face value might sell for $950 or $1,050, depending on market conditions and its features. The coupon payment generally stays the same, but the price changes what you earn overall.

This is where yield to maturity enters the conversation. It estimates your annualized return if you hold the bond until maturity, the issuer makes its promised payments, and you account for the purchase price and repayment amount. It offers a more useful comparison than the coupon rate alone.

For example, buying a $1,000 bond for $950 means you could receive $1,000 at maturity. That $50 difference contributes to your return, along with the interest payments. Pay $1,050 instead, and the eventual repayment creates a $50 loss relative to your purchase price.

A tempting coupon can distract investors from an unfavorable purchase price. Compare yields, not just the biggest interest rate on the screen.

2. A Bond's Safety Depends on Who Owes You Money

Buying a bond means lending money. The issuer promises to pay interest and return your principal according to the bond's terms. Unfortunately, a promise from a financially strong government isn't equivalent to one from a struggling company.

U.S. Treasury securities carry the backing of the federal government. Corporate bonds depend on the issuing company's ability to meet its obligations. Municipal bonds depend on the financial strength and repayment arrangements of the issuing government or related entity.

Credit ratings can help investors evaluate default risk. Agencies such as Moody's, S&P Global Ratings, and Fitch assess borrowers and assign ratings reflecting their opinions of creditworthiness. Investment-grade bonds generally carry lower credit risk than speculative-grade bonds, also called junk bonds.

However, a rating isn't an insurance policy. A company's financial condition can deteriorate, and agencies can downgrade its rating. An attractive interest rate may simply compensate investors for taking on greater default risk. Before purchasing, investigate the issuer's finances, outstanding debt, and ability to generate enough revenue for repayment. Also check whether the bond has collateral backing it or relies on the issuer's general promise to pay. A few extra percentage points won't look nearly as exciting if the borrower struggles to return your money.

3. Selling Early Can Cost More Than You Expect

Individual bonds have maturity dates, but that doesn't mean investors must keep them until then. You can generally sell marketable bonds through a brokerage account before maturity.

The problem? Their market prices fluctuate. When interest rates rise, existing fixed-rate bonds generally lose market value. Why would someone pay full price for an older bond paying 3% when newer bonds offer 5%? The older bond may need a price reduction to attract buyers.

The opposite can happen when market rates fall. Existing bonds with higher coupon payments can become more attractive, potentially increasing their prices. Maturity also influences the damage. Longer-term bonds generally experience greater price sensitivity to changing interest rates than comparable shorter-term bonds.

Then there's liquidity. Some corporate and municipal bonds trade less frequently than others. Finding a buyer at an attractive price may prove difficult, particularly during unsettled markets.

A bond that fits a future expense might work nicely if you can hold it until maturity. A bond that doubles as your emergency fund creates a different problem. Keep money you might need quickly somewhere more accessible.

4. The Issuer Might Pay You Back Early

Getting your principal back sounds wonderful until you discover the issuer had a choice about when to return it. Some corporate and municipal bonds include call provisions. These clauses allow the issuer to redeem the bond before its scheduled maturity date, subject to the contract's conditions.

Why would a borrower do that? Falling interest rates provide a common reason. A company paying investors 6% might decide to refinance its debt at a lower rate. The company saves money, while investors lose their attractive interest payments.

Suppose you purchase a callable bond offering a generous rate. A few years later, market rates decline, and the issuer calls the bond. You receive the redemption payment, but comparable investments now offer less income.

That creates reinvestment risk, an especially frustrating problem for investors who planned their budgets around predictable interest payments.

Read the bond's call schedule before purchasing. Check its first call date, redemption price, and any call protection. Also compare its yield to call with its yield to maturity. The first figure estimates your return if the issuer exercises its redemption option under the specified terms.

5. Taxes, Fees, and Timing Can Change the Deal

Bond income doesn't exist in a tax-free bubble. The rules depend on the type of bond and the investor's circumstances. Interest from corporate bonds generally faces federal and state income taxes. Municipal bond interest often receives federal tax-exempt treatment, although certain private-activity bonds can trigger alternative minimum tax considerations.

Treasury interest faces federal income tax but generally avoids state and local income taxes. That feature can make Treasuries attractive to investors who live in states with income taxes.

Don't overlook brokerage costs, either. Some brokers charge transaction fees or include markups in bond prices. Those expenses can quietly reduce your return.

Another detail involves accrued interest. If you purchase a bond between scheduled interest-payment dates, you may owe the seller interest that accumulated since the previous payment. You'll generally receive the next full scheduled interest payment, which includes the amount you paid the seller. That payment can look like extra income, but part of it simply reimburses you for money already exchanged.

Review the trade confirmation, quoted price, yield, accrued interest, and applicable fees before placing an order. Tax treatment also deserves a closer look if you compare taxable bonds with municipal securities.

Buy the Bond, Not Just the Interest Rate

Individual bonds can help investors plan income and match investments with future expenses. Their scheduled payments and defined maturity dates offer a level of predictability that stock prices rarely provide. But predictability isn't the same as a guarantee. Issuers can default, market prices can fall, and callable bonds can disappear from a portfolio earlier than expected.

A sensible purchase starts with a clear purpose. Decide when you need the money, how much income you want, and how much credit and interest-rate risk you can accept. Then examine the actual bond terms rather than relying on its advertised coupon.

Would you rather own individual bonds with specific maturity dates or let a bond fund handle the selection? Which approach feels more comfortable for managing your money?

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