Medical training is a lesson in delayed gratification. Four years of med school, another three to seven years in residency. The years of training for marginal pay is the stepping stone to gaining wealth in the future. Bonds operate similarly: investing in them is a long-tail strategy, but the payout is often worth it.

Investing in bonds can help your portfolio by providing passive income streams with predictable yield payments. This leaves room to still benefit from the stock market’s potential highs and to offset losses from inevitable dips.

Bond Basics: What to Know

A bond is an “I-owe-you” between a lender and a borrower. When you buy a bond, you are acting as the lender. Whatever agency you buy it from (the federal government, a corporation, a municipality – more on that below) is the borrower. Over a set interval of time, you will earn back your principal, i.e. the amount you lent, plus interest.

It’s worth noting: if you invest in bonds, you own a piece of a borrower’s debt obligation. The higher the borrower’s credit default risk, the greater the bond’s annual interest rate, i.e. the bond coupon, which is the amount you will earn in returns on top of your principal.

Government bonds are the “safest” in that the government does not default on its debt. "Junk bonds” – by contrast – are riskier investments as they are often issued by startup companies or companies that are financially struggling, so there's a risk you may not see a return.

Understanding Bond Types: Key Options for Physician Investors

There are several types of bonds to choose from. Before purchasing any bond, be sure to check its rating and opt for investment-grade bonds. If you invest in lower graded bonds ("speculative" bonds, high-yield or "junk" bonds) beware of the risks!

These are the most common types of bonds:

Treasury Bonds: A Safe Option for Portfolios

Since they’re backed by the United States, these bonds are one of the safest investments as they are backed by the U.S. Federal government, rendering these bonds risk-free.

• How to buy treasury bonds: You can purchase treasury bonds through the government directly via Treasury Direct or through a broker.
• Types of treasury bonds:
  • T-bills are very short term and mature in less than one year.
  • T-notes mature in two to 10 years.
  • T-bonds are long-term investments that mature in up to 30 years.

Treasury bond example: You earn $200,000/year and want to plan for the future by purchasing a 10-year bond to put down a down payment on your home. You anticipate the home will cost $500,000, and a 20% down payment would be $100,000. You choose a 10-year treasury bond with a 3% yield. You compute that in order to earn $100,000 in 10 years with a 3% yield, you would need to invest $74,400 now to afford your down payment.

Treasury Bonds Can Offer Inflation Protection

Treasury-Inflation Protected Securities (TIPS) and I Bonds aim to mirror recent inflation numbers. However there are some differences:

• With TIPS, the principal itself adjusts according to the rate of inflation. So it may increase with inflation over the bond's term. If inflation goes down, however, the principal remains the same. The interest rate is fixed.
• With I Bonds, the interest rate on your principal changes according to inflation. There are two interest rates baked into your purchase: a fixed rate which is set at the beginning of the term and remains consistent through the term, and a variable rate which adjusts every 6 months according to inflation.

Tax Implications of Treasury Bonds

• Federal tax: Interest is fully taxable at the federal level.
• State and local tax: Interest is exempt from state and local taxes.
• Capital gains: Subject to federal capital gains tax if sold before maturity for a profit.

Municipal Bonds: Tax-Advantaged Investing

Municipal governments offer these at the local, county, and state level and leverage the funds to finance public goods or public projects. Municipal bonds (munis) are attractive investment opportunities because of their tax benefits! They also enable you to invest in your community directly. Here's an example from New York City.

Most munis have fixed interest rates, though there are variable ones available too. Variable interest rate bonds (munis or otherwise) won’t provide reliable interest payments, but they can provide better returns if interest rates rise.

• How to Buy Municipal Bonds: Through your brokerage account (you can buy newly issued municipal bonds or previously owned munis from the "secondary market")

Tax Benefits of Municipal Bonds

• Federal tax: Interest is generally exempt from federal income tax.
• State and local tax: Usually exempt from state taxes if you're a resident of the issuing state. May be subject to local taxes depending on the specific municipality.
• Capital gains: Subject to federal capital gains tax if sold before maturity for a profit.

Municipal bonds example: Imagine you buy $50,000 of municipal bonds that are exempt from federal taxes and it returns 2.4% each year for 5 years. Your total earnings of simple interest are $6,000. Alternatively, if you earned this from a stock with qualified dividends, it would likely incur a 15% to 20% capital gains tax, depending on your income, reducing your earnings to $5,100 or $4,800. Ordinary stock dividends are taxed like wage income, so it could be hit with up to a 37% tax. Assuming you make between $100,526 and ​​$191,950 (for tax year 2024), you’d have a marginal tax rate of 24%. Your ordinary stock dividends would be $4,560 after taxes. So your investment in munis would earn you more!

Corporate Bonds: Higher Yields with Added Risk

Companies issue corporate bonds to spur development or maintain operations. The bonds may have a fixed rate (interest rate does not change) or a floating rate (interest rate can fluctuate according to market conditions). Most corporate bonds have fixed interest rates. Risk and expected returns depend on the issuer’s creditworthiness.

• How to buy corporate bonds: You can buy corporate bonds through a brokerage (often in $1,000 increments ) on the primary or secondary market. In the latter case, you'd be buying it from an investor looking to sell.

Tax Implications of Corporate Bonds

• Federal tax: Interest is fully taxable at the federal level.
• State and local tax: Interest is generally taxable at state and local levels.
• Capital gains: Subject to federal capital gains tax if sold before maturity for a profit.

Don’t Skip This Step: Understanding Bond Ratings and Risk

You'll want to check the bond's rating ahead of purchasing it. Moody's and Standard & Poor's are popular bond-rating agencies, and the higher the grade (AAA is the highest) the more likely are to pay you back in time.

Especially with corporate bonds, beware of the risks of investing in low-grade bonds. Even investment-grade bonds aren’t always dependable, as history shows. An infamous example is Enron. Credit rating agencies continued to stand by their decision to judge Enron bonds as investment-grade even as the firm publicly collapsed. Enron’s bonds weren’t downgraded by agencies until right around the time it filed for bankruptcy.

How to Choose Which Bonds to Buy

Apart from government backed I Bonds and EE Bonds, you can search for and buy bonds or bond index funds with your brokerage account. But be sure to shop around, as different brokerages may have different prices for the same bond.

You can choose based on lots of factors. Pay attention to the issuer’s credit ratings or opt for U.S. bonds to manage your risk. Its maturity date can help you reach goals with different time horizons. Filter for higher yield bonds to meet more ambitious (but perhaps riskier to achieve) financial aims.

Alternatively, bond index funds and ETFs are a great way to diversify your portfolio. This is because they are low fee investments that represent a basket of different bonds of a similar type, such as five to 10-year investment grade U.S. corporate bonds.

Join the Discussion

What questions do you have about buying bonds and integrating them into your portfolio? What percentage of stocks vs. bonds do you invest in? Join the discussion in the comments below.