How to Invest in Credit: Bonds, Loans, and Funds

Investing in credit involves lending money to an entity in exchange for regular interest payments and the return of the original amount. This approach contrasts with equity investments, where an investor purchases a share of ownership in a company. Credit investments primarily focus on generating income through predictable payments, offering a different pathway for individuals to grow their wealth. It provides a means to receive a steady stream of income over a set period, making it an attractive option for those seeking regular cash flow.

Understanding the Basics of Credit Investing

Credit investing involves an investor acting as the lender. The principal represents the initial amount of money loaned to the borrower. In return, the borrower agrees to pay interest, which is the cost of borrowing the principal, typically paid at regular intervals.

The yield on a credit investment indicates the total return an investor receives, taking into account the interest payments relative to the investment’s cost. Maturity refers to the date when the borrower is obligated to repay the principal amount to the investor. Creditworthiness, often assessed through a credit rating, evaluates the borrower’s ability to meet their financial obligations. Higher credit ratings indicate a lower risk of default, correlating with lower interest rates offered to investors.

Investing in Bonds

Bonds are a common method for individuals to invest in credit, representing a loan to a government, municipality, or corporation. These entities issue bonds to raise capital for various needs. Government bonds, including U.S. Treasury bills (maturities under 1 year), notes (1-10 years), and bonds (20-30 years), are considered among the safest due to the backing of the federal government. Corporate bonds are issued by companies and offer higher interest rates than government bonds to compensate for increased risk, while municipal bonds, issued by state and local governments, provide tax advantages.

To begin investing in bonds, an investor establishes a brokerage account. This typically involves providing personal details such as name, address, Social Security number, and employment information, along with financial details like annual income and net worth. Once the account is established, it can be funded through various methods, including electronic transfers from a bank account, mailing a check, or initiating a wire transfer. Many online brokerages allow accounts to be opened and funded with no minimum deposit or offer commission-free trading for certain securities.

After funding, investors can research and select bonds using the brokerage platform’s tools, which often allow filtering by maturity, credit rating, and sector. Bond quotes provide the coupon rate (fixed interest rate), yield to maturity (total return if held until maturity), and the bond’s credit rating. When placing an order, investors specify the par value (face value repaid at maturity) and the desired price. Interest payments are typically received semiannually, and at maturity, the principal amount is returned.

The income generated from most bonds is subject to federal income tax at ordinary rates. However, interest from municipal bonds is exempt from federal taxes and can also be exempt from state and local taxes if the investor resides in the issuing state. If a bond is sold at a profit before maturity, this gain is subject to capital gains tax. Brokerage firms may charge commissions for bond trades, which can vary.

Investing in Peer-to-Peer (P2P) Loans

Peer-to-peer (P2P) lending offers another avenue for credit investing by directly connecting individual lenders with individual or small business borrowers through online platforms. These platforms facilitate the lending process, bypassing traditional financial institutions. The P2P model allows investors to fund portions of loans, thereby diversifying their investment across multiple borrowers.

To participate, an investor selects a P2P lending platform, considering factors such as the types of loans offered and available investor tools. Setting up an account on a P2P platform involves a registration process and depositing funds. Platforms vet borrowers, assigning them risk categories or credit grades based on factors like FICO scores, debt-to-income ratios, and loan purpose. This assessment helps investors evaluate the risk associated with each loan.

Investors can browse and select specific loans based on criteria provided by the platform, such as the borrower’s credit profile, loan purpose, and interest rate. Some platforms also offer automated investment tools that allocate funds to loans meeting predefined investor criteria. Once a loan is selected, the investor commits capital to fund it. P2P loans typically have fixed interest rates and repayment terms, often ranging from three to five years, with interest rates varying widely, starting around 6.99% for highly creditworthy borrowers and potentially reaching 15.5% to 19% for higher-risk loans. Investors generally realize an average return on investment in the 6-8% range across diversified portfolios.

Platforms handle the disbursement of funds and the collection of monthly payments, which are then passed on to investors. Platforms charge fees, such as servicing fees that can be around 1% annually on payments received, and generally do not involve the same commission structures as traditional brokerage accounts.

Investing Through Credit-Focused Funds

Investing through credit-focused funds provides an indirect method of participating in the credit market by pooling money from numerous investors to acquire a diversified portfolio of debt instruments. These funds can take various forms, including bond mutual funds, bond exchange-traded funds (ETFs), and debt-focused closed-end funds. They offer access to a wide range of debt securities, such as government bonds, corporate bonds, and municipal bonds, often categorized further by credit quality (e.g., high-yield bond funds).

These funds are typically purchased through a brokerage account, which an investor would have already established for other investment activities. Researching credit-focused funds involves evaluating several factors, including their expense ratios, stated investment objectives, historical performance, and the types of bonds held within their portfolio. Expense ratios, which cover the fund’s operating costs, are a significant consideration; for instance, the average expense ratio for bond mutual funds was around 0.37% in 2023, while bond ETFs had an average of 0.11%.

Placing an order to purchase shares of a mutual fund or ETF is done through the brokerage platform, similar to buying stocks. Funds distribute income to shareholders, which primarily consists of interest income from the underlying bonds and any capital gains realized from the fund manager’s trading activities. These distributions are generally taxed as ordinary income, with capital gains taxed separately. Municipal bond funds, similar to individual municipal bonds, may offer federal tax-exempt interest income, and potentially state and local tax exemptions if the fund holds bonds from the investor’s state of residence. Other fees, such as sales loads (up to 8.5%) for some mutual funds or advisory fees, can also apply depending on the fund type and brokerage service chosen.