How to Invest in Bonds: General Information
In this overview, we will discuss one of the main investment instruments – bonds. Investors use bonds to preserve and increase their capital.
A bond is a debt security with fixed revenue that is used by the state or companies to attract money by borrowing it from investors (funds, companies, or individuals). Bonds are often issued for raising money for certain projects. In essence, a bond is a credit agreement for a certain period with a fixed interest size.
When buying bonds, an investor provides the issuer of the bonds with an amount of money that the company will be using later. In exchange, the issuer will pay off an amount of interest on this sum during a set period, and when it is over, will pay back the whole sum. Unlike a shareholder, a bondholder normally has no share in the company, no right to participate in the shareholders' voting, or receive dividends.
Some bonds are rated by agencies, such as Moody's and Standard & Poor's, to help investors evaluate their quality. Such ratings are used for estimating the probability of repaying the borrowed sum. Normally, ratings of bonds are of two types: credit rating (trustworthiness) and profitability rating.
The main characteristics of bonds are:
- The Time of Maturity is the date when the issuer must repay the borrowed sum. The term may vary from one to thirty years
- Face Value or Principal is the amount that will be paid to the investor before the Time of Maturity. It can be paid in parts
- Coupon is the revenue that investors receive. It may be fixed or floating. Usually, the interest is received through periodic payments on a schedule
Normally, there are two types of markets for bonds – primary and secondary:
- The primary market is the one where issuers sell their bonds
- The secondary market appears later when investors start selling their bonds to other investors. The price of bonds in the secondary market changes depending on supply and demand, interest and inflation, and also on the number of Coupon payments and time left until the Time of Maturity
The overall revenue from bonds consists of two parts: coupon revenue (from the interest paid) and discount revenue (from the difference between the amount of the bond purchase and the redemption).
Types of bonds
- Corporate bonds are debt instruments issued by a company to attract capital for development, research, or the introduction of inventions. The interest received from corporate bonds is taxable. Simultaneously, the interest on corporate bonds is usually higher than on municipal or state bonds
- Municipal (local) bonds are issued by cities, towns, regions, etc. to gather money for funding public projects, such as the construction of schools, hospitals, roads, etc. Unlike corporate bonds, the interest on local bonds is non-taxable
- State (treasury) bonds are issued by the government of a country. As long as they're fully secured by the government, they are considered the most trustworthy bonds. However, the interest on state bonds is much lower than on corporate ones
The advantages of bonds are:
- Capital saving. Bonds with a high rating are a more trustworthy instrument than stocks. They are less prone to market risks and can be used by investors as an option to save their capital
- Stable revenue. Bonds provide a fixed revenue received on a schedule as the Coupon
- Diversification. Investments in bonds, stocks, or other assets will help create a balanced investment portfolio
The drawbacks are:
- Relatively low profitability. Bonds are considered more trustworthy but less profitable than stocks or other financial instruments. If the inflation level is higher than the Coupon revenue received by the investor, the purchasing power of their capital will decrease
- Interest rate fluctuation risk. When the interest rates of central banks rise, the prices of bonds drop; meaning that bonds that you are holding can also drop in price. Interest rate fluctuations are the main causes of instability in the bond market
- Credit or investment risk in the case the issuer does not repay the borrowed money. Increased credit risk is a characteristic of profitable bonds with a low rating
Advice on investing in bonds
- Check the Time of Maturity, i.e. the date when your investments will fully return to you. Before buying a bond, consider what term you are prepared to invest in.
- Check the rating of the bonds. The rating represents their trustworthiness. The lower the rating, the higher the default risk – meaning you can lose your investments. AAA is the highest rating (by Standard & Poor's system). Bonds with a C rating and lower are considered unreliable, with high default risk.
- Study the service record of the issuer. The history of the company might be useful when considering whether to invest in the company or not.
- Choose a reliable broker. Make sure you select a broker that has a license and is listed in the special ratings of brokers.
- Think about how much you are prepared to risk. Bonds with a lower rating normally suggest higher profitability explained by the high-risk level. More reliable bonds offer lower profitability. Try to find the golden mean.
- Go for a balanced approach. Bonds can diversify your investment portfolio and balance investments in stocks and other assets.
- Study the commission fees and other expenses. If you invest in a bond fund, check out the fees and the types of bonds present in the fund.
Bonds are considered a reliable instrument in the financial market, and their profitability is moderate. Most often, investors use bonds for balancing their portfolios that include bonds, stocks, currencies, and other assets. Learning how to invest in bonds will help a skillful investor to save and increase their capital.