How to Invest in Bonds: A Guide for Beginners
What is a bond investment?
First things first - What does it mean to invest in bonds?
Simply put, a bond is a loan. A loan from you, the investor, to a government or a company. A company or a government can borrow money from investors by issuing bonds. In return, they pay interest to the investors. Companies and governments frequently issue bonds. They do this to finance new projects or ongoing projects. A government may issue a bond to fund the construction of a railroad. Whereas a company might issue a bond to pay for business expansion, for example.
Investing in bonds
So now that you know what a bond is, the next question is: how to invest in bonds? Let’s illustrate this type of investment with an example.
Let’s say a government needs money to build a new park and they decide to issue bonds to raise money for this project. Each bond is worth €1000. The government promises to pay this loan back to investors in 10 years. This is called the maturity of the bond. To make this loan more attractive to investors, the government agrees to pay an annual interest rate of 5%. In the world of bonds, we call this a coupon rate.
Let’s say you buy a bond for €1000. Now let’s fast forward. Each year, the government pays you €50. These regular interest rates continue for the length of the bond. Which is, in this case, 10 years. Once the bond reaches maturity, you redeem your bond. And the government returns your €1000 initial investment, also called the principal. This bond turned out to be a good deal for both the government and you, the investor. The government got the money it needed to build a beautiful park. And you received regular interest payments and the return on your initial investment.
Just like with shares, bonds can be sold to other traders on the market. When investors believe they can get a better return elsewhere, they may decide to sell their bonds. If the supply of bonds increases to a level that exceeds demand, this will cause the price of the bonds to fall. But the amount paid out as coupons will not change. So, the yield on the bond will rise.
Take the example we mentioned earlier. You bought a bond for €1000 for 10 years. But after a while, the value falls to €900. Now, the interest rate rises from 5% to 5,6%. That’s because it still pays €50 in interest each year. On top of this, as the bondholder, you would still receive €1000 at maturity. That’s €100 more than you can now buy it for.
However, the bonds’ price could also rise above their nominal value, if there is high demand for bonds. This can happen in times of economic uncertainty when investors are struggling to find equivalent returns elsewhere. Of course, in this scenario, if you buy a bond from another investor, you will get paid back less than your initial investment once the bond matures.
Types of bonds
There are several different kinds of bonds you can invest in. We’ll cover three of them here.
Investing in government bonds
When you invest in a government bond, you loan money to a government in return for an agreed rate of interest. These are generally regarded as one of the safest investments. That’s because governments don’t go bankrupt that easily. The government uses the money you loan them to fund projects or infrastructure. In return, the government will make fixed interest rate payments. The frequency of the payment is specified by the bond coupon. Maturity years for a government bond can range from 1 year to 30 years or more.
Investing in municipal bonds
Where government bonds are issued by a central government (the U.S. government for example), municipal bonds are issued by local governments. Such as city, state, or county government. A lot of people choose to invest in municipal bonds, also known as munis because they offer tax benefits. The exact tax benefits that come with investing in municipal bonds are of course dependent on the country you live in. Municipal bonds generally offer lower yields than corporate bonds. But the interest is usually tax-free. This unique feature of municipal bonds is what makes them attractive and lucrative for investors.
Investing in corporate Bonds
Corporate bonds are a type of investment where an investor loans money to a corporation. In return for this loan, the corporation pays the investor interest until the bond reaches maturity. Just like with the other bonds mentioned, once the bond reaches maturity, the investor will receive back the amount originally invested. Corporations usually issue bonds to finance operations and expansions. Corporate bonds often have a higher coupon rate than government bonds or municipal bonds. Simultaneously, corporate bonds are generally a lower-risk investment than investments in stocks. You can purchase a corporate bond individually or as part of a fund.
Why invest in bonds?
Many people choose to invest in bonds. And for good reason. Here are some of the benefits of investing in bonds:
- Bonds are viewed as a less risky investment than stocks. It is seen as a stable and predictable form of investing.
- You receive regularly scheduled payments in the form of coupon rates. Compared to stocks, whose profits and losses are driven by market forces, which makes them less predictable.
- When the bond reaches maturity, you get the return of your invested principal.
- Investing in bonds can be a way for you to diversify your portfolio.
The risks of investing in bonds
As we’ve seen, investing in bonds is generally seen as a safe and stable choice. Especially compared to investing in stocks. However, like any financial investment, investing in bonds is not without risk. One risk that you face as an investor is the possibility that the issuer (the government/company that issued the bond) defaults on paying back your principal investment. This is called the default risk.
Bonds with higher default risk, also come with higher coupon rates. The amount of risk is mostly determined by the financial stability of the issuer. Most governments, for example, are generally stable issuers. That’s why government bonds offer relatively low coupon rates. Corporate bonds typically come with greater default risk. That’s because there is a real chance that the company will go bankrupt. To compensate you, the investor, for the higher risk of losing your initial investment, the coupon rate is higher. High risk, high reward.
Are bonds a good investment in 2022?
We’ve looked at the definition of bonds, how to invest in bonds, the different types of bonds, and the benefits of investing in bonds. But that’s all generally speaking. As you probably know, timing is essential when it comes to financial investments. So, you might wonder: “Are bonds a good investment in 2022?”
We’re at a point in time where banks pay virtually no interest on the cash in your bank account. Where the stock market is dropping. At the same time, bonds, historically seen as somewhat of a boring investment, can offer up to 9,62% interest. Prices of most goods are rising and the cash in your bank account is losing value quickly. All the while, the average savings account only pays 0.07% interest. Let’s say you have €10.000 in savings. That means just €7 a year in interest from your savings account versus €962 a year from investing in a bond with 9,62% interest. So, are bonds a good investment in 2022? We believe so because right now they offer a rare low-risk/high reward opportunity.
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This blog is for educational purposes only. The information we offer does not constitute investment advice. Please always do your own research before investing.
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