If you are wondering how to invest your money, you may have thought about investing in bonds. Yet, investing in bonds is a tricky task with many complexities and risks involved. Here, we look to explain the world of bonds so you can understand many of the difficulties in bond investing.
Firstly, we define what exactly bonds are and why it may be a good idea to buy bonds in the first place. We also explore different types of bonds and highlight the dangers of investing in this vehicle.
Evaluate if bond investing is suitable for you. To do so, keep in mind your individual needs and circumstances.
We all have different risk profiles. Your risk profile depends on various factors. They are your income, outgoing expenses, saved money, and other more subjective lifestyle choices.
Finally, risk appetite needs to be a consideration. We all have different appetites for risk. Risk appetite is defined as how willing an individual is to take on a particular investment.
What Are Bonds?
Bonds are a financial product. Governments and companies issue them. Bonds raise cash without a company needing to sell parts of their company. Bonds raise funds for entities as a form of debt.
In effect, when a person buys bonds, they are giving companies a loan. A company must then pay back that loan over a set amount of time. Additionally, the company pays a little more back to reimburse the person loaning money. That extra amount is known as interest.
The amount of interest earned on a bond is set by interest rates predetermined before it is bought.
Why Invest in Bonds
Investing in bonds offers many advantages to investors, but what are they? Here, we investigate precisely why investing in bonds may be attractive.
Firstly, a bond can provide investors with an income through a regular interest payment. For those that want or need an income on which to survive, this can be crucial.
The income generated from bonds also has a secondary advantage. The set income allows investors to budget for the future. Potential profit on other investments can be challenging to forecast. With bonds, the amount you will earn (and when) is already determined from the outset.
Secondly, if bond issuers go into liquidation, bondholders are prioritized. They are the first group to be repaid any available money. As a result, the risk of losing an initial investment is minimized.
Thirdly, bonds are rated by credit rating agencies. Ratings make for easy comparison to see the creditworthiness of bond issuers. As a result, making informed investment decisions is more straightforward as other asset classes are not rated in the same way.
Finally, bonds can provide a means of portfolio diversification. They are different from stocks, property, or cash. As a result, they are also subject to other investment risks. Having them as part of a portfolio can help reduce losses as and when they occur.
When you consider all these factors, bonds can help protect your capital. Choosing to invest in bonds can be challenging but hugely rewarding too. They can help bring an income and can hold their value when other investment classes falter.
Ways to Invest in Bonds
If you decide that investing in bonds is right for you, you need to know how. In practice, there are many different ways that investors can buy bonds and invest in them to make money.
Firstly, it is possible to buy a bond through a broker and hold it to its maturity.
In doing so, you will receive all the set interest over the bond’s life. That interest can either be reinvested elsewhere or used as an income. Bondholders will then receive their initial investment, known as the principal, at maturity.
Secondly, investors can invest in bonds by buying units in a bond fund to access a broader bond strategy. By buying a wider range of bonds, investors have minimized their investment risk.
Thirdly, it is possible to gain exposure to bonds by buying units of funds that invest in many asset classes. Mutual funds are good examples of this investing strategy. Buying into mutual funds can provide a fully diversified portfolio. Plus, these funds do not need any day to day portfolio management themselves.
Finally, another bond investment strategy is to buy at a low price and sell at a higher one. When using this strategy, investors must remember how to calculate potential profit. The loss of future interest payments needs to be factored in.
Whichever strategy you choose, it is vital to find a good broker or platform. Doing so helps you make efficient investing decisions. If you don’t, you could find yourself losing out on what would have been effective bond purchases.
Types of Bonds
There are many types of bonds available on the market. It is imperative to be aware of as many as possible. An in-depth understanding is key to buying the most suitable bond for you. The most common types of bonds are:
Canada Savings Bonds
Canada Savings Bonds are bonds issued by the Canadian government. Other government bonds from other countries have different names. For example, a US-issued government bond is called a Treasury.
There are many types of Canada Savings Bonds. They are structured in different ways. They vary in the interest rates they pay, as well as the maturity dates set.
The Canadian government issued these bonds as a way to raise funds. The government then uses those funds on larger infrastructure projects. Canada Savings Bonds also funded other government policies. They were attractive to investors thanks to a competitive and regular interest payment. Bondholders could also redeem them when required.
Canada Savings Bonds are typically considered a low-risk investment. Many investors see Canada as an economically strong country.
Municipal bonds are bonds issued by states or municipalities. They are a way that smaller communities can raise funds without a larger issuance of government-backed bonds.
As with any other bond, they are assigned interest rates and maturity dates. There will also be a payment structure that potential investors need to evaluate.
The interest rates attached to them should be higher than those seen on government bonds. The higher rate reflects the higher risk of municipal bonds than a government issue, like Canada Savings Bonds.
For some, that chance is worth taking to achieve higher yields on their portfolio. However, investors need to weigh that risk with their own investment requirements.
Foreign bonds are a type of bond a foreign company issues in another market, in a currency, not their own. Companies do so to raise collateral in a foreign currency. The company can then run more efficiently and economically in foreign markets.
As with other types of bonds, foreign bonds will have an interest rate, maturity date, and payment structure. Investing in foreign bonds is a means of investing in a foreign company. However, it is done in the investor’s domestic currency.
When a bond issuer is a foreign company, it will have a higher interest rate or yield than other domestic bonds. The higher rate reimburses the bondholder for the extra risk. The added risk comes from being a foreign entity.
Corporate bonds are a type of bond issued by companies. Companies issue bonds or become a bond issuer to raise collateral to help grow a business. A corporate bond will ordinarily have the same features as a government bond. It will offer interest payments and have a maturity date set by the issuing company.
The critical difference between a corporate bond versus government bonds is that they carry a higher risk. Corporations are more likely to go bankrupt than a government. For that reason, investors are taking the risk they may not receive their initial investment back. As a result, they offer higher yields than government bonds.
Corporate bonds can also be known as investment grade or high yield bonds. Each bond issued will be rated by a rating company. The credit rating an issuer receives will determine whether they are investment grade or high yield. A high yield bond carries a higher risk.
Can Bonds be Volatile?
Investing in a bond is often done to invest cash in a safer place than other asset classes. However, is that really the case? Can bond investments return a more stable financial growth than other asset classes?
Investigating whether bonds can be volatile helps answer these questions. When questioning bond volatility, it is necessary to look at a bond’s maturity date. Bonds will always carry far more volatility risk if they have a long term maturity.
Maturity is a key determinant factor in volatility. It allows more time to see a rise or fall in the bond’s price. Additionally, interest rates may have changed drastically in that time. That change affects the amount that can be earned on reinvested interest.
However, other factors are essential to bear in mind when looking at volatility. The underlying creditworthiness of the company issuing a bond is critical. If a company is not a quality holding, it can be highly sensitive to other market movements.
Remember, high volatility can still make for a profitable investment. High volatility causes significant price swings – down and up. An investor needs to tolerate this over the course of a bond’s life.
Dangers of Investing in Bonds
There are many dangers that investors should be aware of before buying any bond. They are:
- credit risk
Credit risk is the danger that an institution becomes insolvent. An investor can lose their initial investment if they buy a bond from a company that goes bankrupt. Additionally, they lose out on any future interest.
- inflation risk
Inflation risk is related to the time it takes for a bond to mature and if prices have risen overall. A bondholder can lose purchasing power when they receive their initial investment amount back.
- interest rate risk
Interest rate risk is perhaps the most significant risk posed to bondholders. If interest rates rise, the impact on bond prices is that bond prices decrease. As a result, bondholders can lose money should they have hoped to sell their bond before maturity.
The Bottom Line
Investing money and buying bonds can be complicated. There are so many factors that affect them. So much so that making a profitable investment decision can be challenging. In fact, not only can it be hard, it can be costly.
Buying the wrong bond can materially affect your portfolio’s final asset value. For that reason, it is imperative to carry out prudent due diligence on any bonds. Do so with your risk profile in mind. Doing so will help reduce any losses.
Finally, always carry out due diligence on a bond. Due diligence on bonds includes investigating the creditworthiness of the underlying institution. Plus, it is crucial to know how a bond is structured to mitigate as many risks as possible. For this reason, investing in fixed income products like bonds can be tricky. But when you get it right, the rewards can be significant.