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How To Invest In Bonds

How to invest in bonds

Besides equities, bonds are another popular investment instrument in today’s investing world. They are part of the capital market and with currently up to $123.5 trillion in valuation, according to the latest statistics, the global bond markets make up an even greater outstanding value than equities. Different kinds of bonds are held by small asset managers as well as large institutional investors like pension funds from all over the world.

What are bonds & how do they work?

Bonds are fixed-income securities. Companies or governments issue bonds to borrow money for their own financing. As such, they are a liability of the issuer. The bond issuer is also called the debitor, who is given money by the bond buyer or creditor. It is the latter, who is earning a fixed-income yield for providing the capital.

Every bond is issued with an interest rate and a maturity date, when the money that was borrowed will have to be repaid. This is called the maturity date. Once a bond has expired, the so-called principal – the initial size of the borrowed money – is repaid. A bond’s interest rate as well as its maturity date are agreed upon up front. Also settled in the agreement is whether interest payments (coupon payments) are paid annually or at the end of the bond’s term.

In contrast to the trading of equities, bond trading is not expressed in a price, but in percentages. A bond buyer therefore does not acquire a certain number of shares (a specific quantity of a particular stock’s units) but parts of a bond at hand.

Watch the video: Currencies, Bonds & Inflation In The Current Macro Regime

Why issue bonds? 

From the issuer’s point of view, issuing bonds is a way of raising capital without the need to deposit collateral. In the case of bank loans, collateral is required and when it comes to the issuance of shares, shareholders – the buyer of the shares – need to be given voting as well as participation rights in the company itself. This means that profits have to be shared. The purchase of a bond makes the purchaser a creditor rather than a shareholder. Through the eyes of the bond buyer, one benefit is that in case of bankruptcy, bond holders are privileged over shareholders. Just as with equities, bonds can also be resold to other investors on the secondary market – at best for a profit. 

Types of bonds

There are different types of bond products that mainly differ in risk and therefore in yield because they are issued by different counter-parties. The most popular are:

  • Corporate bonds: As its name suggests, a corporate bond is a debt securities issued by a company. These corporate bonds offer a higher yield than government bonds because historically the risk of default is higher with companies than with government entities. Also, corporate bonds are not as liquid as government bonds like Treasuries, although there are some corporate bonds that have quite high liquidity. Among the most liquid corporate bonds are the ones issued by companies like Apple, Amazon or Google.

Buying and selling of corporate bonds can either be done through the primary or the secondary market. Purchases are made through brokerage firms like banks, bond traders or brokers.  

  • Municipal bonds: These debt securities – also referred to as “munis” – are issued by states, cities and other local government entities mainly to finance public projects and offer public services. For example, if a new bridge, a train station or any other public endeavour needs to be financed, municipal bonds are issued to raise funds.

Municipal bonds are available through the primary market as well as the secondary market. Brokers who facilitate the buying and selling of municipal bonds are required to register with the Municipal Securities Rulemaking Board (MSRB), which governs the “muni” bond market.

  • Treasury bonds: Treasury bonds are issued by the US government. As one of the most trusted debtors, the US government’s Treasury bonds are among the safest bonds, which is why they are generally considered a risk-free investment. Correctly speaking, Treasury bonds have to be subdivided into two further categories: Treasury notes and Treasury bills. Treasury bills are issued for terms less than a year. Treasury notes have a maturities of two, three, five, seven or 10 years. Anything above 10 years, which are Treasury securities for 30 years, is called a Treasury bond.

Treasury bonds can be bought through competitive auction processes on the primary market. This buying opportunity is usually reserved for a chosen set of actors, called primary dealers. The other way is going through a bank or broker that acts as an intermediary on the secondary market, where Treasury owners (the primary dealers for example) sell the bonds before maturity.

  • Junk bonds: These bonds belong to the category of corporate bonds as they are issued by companies. Because these companies are given a low credit rating by rating agencies, their bonds are considered risky (riskier than better rated corporate bonds), which is why they typically have higher yields. Therefore junk bonds are sometimes also referred to as high-yield bonds or non-investment grade bonds. So, although these bonds have a higher yield, investors need to be careful as the risk of default is higher too. 

Like other bond offerings, junk bonds are available for purchase through the primary as well as secondary markets that are facilitated by all sorts of brokers and banks. 

  • Bonds funds: Bond funds are also called debt funds as they represent a pooled investment vehicle that invests in either government, municipal or corporate bonds. In that sense, a bond fund is similar to a mutual fund but instead of investing into stocks, a bond fund buys many different bonds. By buying several bonds and pooling them together, a bond fund is a way to achieve portfolio diversification. As such a bond fund can be considered a safer bond investment than investing in individual bonds. 

Bond funds are offered by investment managers and brokers. Popular bond fund issuers are Vanguard, Blackrock or Fidelity. In order to buy into a bond fund, an investor has to buy the shares of a respective fund. As such, a bond fund allows an investor to buy and sell fund shares each day on the open market. They represent a low-cost option to conveniently buy a collection of bonds.

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Advantages & Disadvantages of Bond Investing

There are several advantages and disadvantages to owning bonds. Here are some for each.

Advantages: 

  • Bonds are generally considered a conservative investment vehicle as they historically have carried less volatility risk than equities. Investors that are looking for an investment option in order to be exposed to markets and not have their money sit in bank accounts but nevertheless want to play it safe, should be looking at bonds.
  • Bonds provide a predictable income stream in the form of a fixed-income yield that is paid in regular coupon payments.
  • Bonds are one of the most popular ways to diversify a portfolio. Historically, bonds have also shown an inverse correlation to equities. If equities have fallen in price, bonds have kept up or have even risen in price. 
  • Investing in bonds makes you a privileged investor in case a company goes bankrupt. As bond investors are higher up the hierarchy, their claims are met prior to these equity holders.
  • Unlike stocks, there exist clear ratings for bonds as they are rated by well-established credit rating agencies. 

Disadvantages: 

  • Because bonds have been the less risky alternative to equities historically, their returns have also been lower.
  • There is direct exposure to interest rate risk as the interest rate affects the value of a bond directly. If interest rates rise, bond prices go down and vice-versa. 
  • In today’s low to zero interest rate environment bonds yields have fallen significantly. Some bonds (especially government bonds) do already have a negative nominal yield.
  • Bonds also have inflation risk. If the inflation rises and outpaces the fixed income a bond is providing, a bond investor is losing purchasing power.
  • While Treasury bonds are highly liquid, some bonds carry liquidity risk as there are not a lot of buyers and sellers.

Are bonds a good investment?

In times of low or even negative interest rates, bonds can be a bad choice for investors. If a bond yield is negative in nominal terms, this means that a bond investor will be getting less of the principal paid back once the bond expires. This surely sounds like a bad deal and should be taken into account.

At the same time, real yields should also be considered when investing in bonds. While the nominal yield of a bond can be positive, its real yield can still be negative. This is the case when inflation is higher than a bond’s nominal yield, making the investor lose money in real terms. So, bonds investors should always carefully look at nominal yields, real yields as well as inflation and inflation expectations. 

Watch the video: Breaking down bond Yields (Nominal vs Real)

Additional factors to consider, when investing in bonds are:

  • Bond rating: An investor should know what rating a bond has. The better the rating, the lower the credit risk of the bond issuers. This is an important indicator to assess the overall risk of a bond investment.
  • Maturity: An investor should also know when a bond expires, which happens on its maturity date. So before investing into a bond, know how long your money will be tied up in the investment.
  • Minimum investment: Some bonds and bond funds have minimum investment. 
  • Consider diversifying: Bonds are a good way to diversify a classical portfolio. In addition to diversifying your overall portfolio, an investor might also want to diversify one’s bond holdings by investing in a bond fund as well.
  • Fees and commissions: When investing in bonds, different brokers have different fee structures. An investor should make sure in advance he understands what and how much he is paying for his bond investments.
  • Timing and overall market situation: The current macroeconomic market situation should be assessed carefully. This also means that an investor should pay attention to central banks and their interest rate policies as they influence the prices of bonds. 

How & where to buy bonds

While equities are traded on public stock exchanges, bonds are usually traded over the counter, which means that they are traded in a decentralized fashion rather than on a centralized trading platform. Over the counter buying and selling generally goes through brokers. These brokers on the bond market are thoroughly regulated by the Financial Industry Regulatory Autority (FINRA) that makes sure fair transaction prices and quotes are displayed. 

While brokers handle the over the counter secondary market for bonds, there is also the possibility – especially for US Treasury bonds – to buy bond vehicles from the issuer itself. This sort of buying (and selling) happens on the primary market. Bond funds are usually bought through popular investment managers like Vanguard, Fidelity or Blackrock.

RELATED CATEGORIES: Bonds, Investing