Understanding the Pros and Cons of Investing in Bonds

In 2020 the global bond market reached an outstanding value of $128.3 trillion. There are many assets that people can invest in, and bonds are one of the most popular choices. They provide a way for you to use your money to generate more income, but they do come with some potential disadvantages. For a rundown of what bonds are, how to invest, and the pros and cons of bonds, keep reading.

What Are Bonds?

Bonds are a financial asset, but rather than having ownership, they represent a loan from you to the bond issuer. When you buy one, you’re loaning money to the government or another institution. They’ll then pay you interest for a fixed period.

The money you’ve loaned out is known as the face value, or principal, and the interest payments you receive are known as coupons. At the end of the agreed period, the institution will pay you back the principal in full.

Investing in Bonds

The main reason people invest in bonds is to make profits, and there are two ways you can do this. The first method is to buy a bond and hold it while collecting interest payments. Once the agreed period is up and you receive the principal back, your total profits will be equal to all the interest you were paid.

For example, if you buy a 10-year bond for $10,000 with 3% interest, you’ll be paid 3% each year through 2 instalments (every 6 months). This interest compounds, so while the first year would be $300, the second would be slightly higher, and so on. After 10 years, you get the initial $10,000 back.

The second method of investing is to buy a bond and then sell it for a higher price than you paid. This is dependent on the market value. If you were to buy the same bond as above, for example, and then sell it once the market value increases, you could make a profit on it.

The value of a bond can rise if the institution’s credit risk profile improves. This is because it means they’ll have a better chance of repaying the bond at maturity. The value can also go up if the prevailing interest rates go down.

Types of Bonds

Before you do any bond investing, you should know about the different types available. Each type has different advantages and disadvantages.

Corporate Bonds

These are issues by companies rather than governments. This means they have a higher chance of defaulting, but they also generally pay more interest.

Municipal Bonds

Also known as “muni bonds”, these are issued by local government entities like states and cities. The purpose of these is to fund public projects or services such as parks or bridges.

Treasury Bonds

These are also called T-bonds and are issued by the US Government. These tend to offer quite low-interest rates, but also have very little risk of defaulting.

The Pros and Cons of Bonds

Other than bonds there are various types of assets you can invest in. When thinking about investing in bonds you should weigh up the different advantages and disadvantages associated with them.

Pros

One of the main advantages of bonds is that they provide safety as an investment. The income is generally more predictable than other investment opportunities, meaning you have a better idea of the kind of profits you’ll make. They are also less volatile than other assets, so it’s unlikely the value of a bond will suddenly drop.

The income from bonds is not just predictable in terms of the amount you’ll make, but also its regularity. Interest payments are paid twice a year so you can handle your finances accordingly. If you decide to sell for a profit, you can do this whenever you choose.

If you purchase a muni bond, the money you invest will be going towards something to help your local community. This could be a school, hospital, public garden, or more.

If you’re already an investor, you probably know that it’s good to have a diverse portfolio. Having a mix of stocks, bonds, and other assets can reduce your financial risk and increase your potential to make profits.

Cons

While they are one of the more secure investment options available, there are some potential downsides to investing in bonds. One of the most obvious is that the money you invest will be locked away for long periods, and you won’t be able to access it without selling your bonds.

When buying bonds you’re making a long-term commitment, and the issuer may change their interest rates while you’re still holding. If you invest at an interest rate of 3%, then the issuer increases their rate to 4%, and the value of your bond will go down. You won’t be able to take advantage of the new interest rate unless you invest again.

One of the main risks of bonds is the possibility of the issuer defaulting. This is uncommon, but if it does happen you could lose your principal, your interest payments, or even both.

Compared to the stock market, the bond market is lacking in transparency. This means that brokers may sometimes charge higher prices than they should. It can be harder to determine if the price of a bond is accurate for its value, so you might end up overpaying.

Bonds remain one of the safest investments, but along with this, it means that you’ll usually get smaller returns. When it comes to investing it’s often the case that higher risk means a higher reward.

Should You Invest in Bonds?

Before investing it’s important to weigh up the pros and cons of bonds. They’re generally secure and reliable, and can even help out your local community. Just remember that you may not make the best returns, and there’s always a possibility of losing your investment.

If you want to start investing, it’s crucial that you know the market and understands what you’re doing. At CFI.co we provide updates and information on all things finance, business, and economics. Click here to sign up for our newsletter or contact us with any questions today.

How to Invest in Bonds: A Beginner’s Guide

Investing in bonds provides low-risk cash flow for your portfolio. You can invest in various types of bonds.

Corporate bonds give you access to companies. These bonds come with higher risk but also higher interest rates.

Cities, states, and local governments issue municipal bonds. These bonds come with fewer risks and, therefore, lower rates.

The Federal Government also issues bonds. Their Treasury bonds come with the least risk.

This structure translates into the lowest interest rates.

Each of these bonds can bolster your portfolio. However, knowing the types of bonds only presents a starting point. Gaining additional insights will help you make smarter investing decisions.

Want to learn how to invest in bonds? This article will cover everything you need to know.

How to Invest in Bonds

You can either invest in bonds via a broker or ETF. Brokers let you buy individual bonds in increments of $1,000. 

Brokers give you access to corporate, municipal, and treasury bonds. You can also purchase treasury bonds directly from the government’s website.

You cannot spend $100 or $1,400 on individual bonds. You must invest $1,000 at the minimum. 

Not everyone likes the high entry point for bonds. Bond ETFs offer a reliable solution. Instead of buying bonds, you buy a basket of bonds.

You can purchase fractional shares of an ETF instead of entire shares. You can get started with an ETF of bonds for as little as $1. 

Can the Issuer Pay off the Bond?

When you buy bonds, you must consider an issuer’s ability to make interest payments. Higher risk translates into higher interest rates. This phenomenon explains why treasury yields are so low.

You can make more money with non-defaulting corporate bonds. Review a company’s balance sheet to see if it can cover interest payments. A company’s obligations and growth potential impact its ability to cover the debt.

Establish Your Risk Tolerance

Not every bondholder invests in corporate bonds. Some investors believe these bonds carry significant risks not worth the risks. These investors will focus on Treasury and municipal bonds.

Other investors believe T-bills and municipal bonds carry insufficient potential. They don’t want to park their money for years in exchange for a low return. These investors will take on riskier assets such as corporate bonds.

Before investing in bonds, assess your risk tolerance. Your risk tolerance determines how much risk your portfolio can bear.

Risk tolerance is personal for each investor. Your personal budget plays a critical role in determining which assets you select. 

Younger investors often invest in riskier assets. They have more income potential and time to weather downturns.

Older investors tend to pick low-risk assets that produce minor gains. Growth is better than no growth for these investors. Some of them have their eyes on retirement and don’t want to rock the boat.

Bond Maturities

Bond maturities indicate how long a company has to pay off the principal fully. Bonds with higher maturities take longer to pay in full.

Issuers reward long-term bondholders with higher interest rates. A 5-year bond will have a higher interest rate than a 2-year bond.

Higher rates will increase your cash flow. However, it takes longer to receive your principal.

Bond investors should also review inflation rates. A bond yielding 2% will lose money because inflation outpaces the yield.

This issue always concerns bondholders. However, today’s inflation growth makes it more glaring.

You can get higher returns with corporate bonds and stretched-out maturities. Some investors buy into a combination of short-term and long-term bonds.

This strategy gives them access to some of their initial principal each year.

Bondholders often reinvest their principal proceeds into other bonds. They will do the same with interest payments.

If interest payments do not provide enough cash flow to buy a bond, you can buy Bond ETFs.

Selling Bonds to Realize Your Gain or Loss

You do not have to wait for the maturity date to cash out on your bond. Some investors prefer to sell their bonds before the maturity date. 

They realize the gains or losses upon selling. Profits will increase your taxes, while losses count as tax deductions.

Bonds are highly liquid assets. You can quickly sell a bond, realize the proceeds, and shift to another asset. Some bondholders switch up their holdings to capitalize on better opportunities.

Why Some Investors Pick up Bond ETFs

Some bondholders prefer to own individual bonds. They want to pick the best bonds and outperform the market. 

Other investors opt for bond ETFs. They don’t want to try and beat the bond market.

These investors prefer to mirror the market and reap average cash flow. Nothing is wrong with achieving average returns.

Exchange-traded funds require less work than researching individual bonds. You review an ETF’s holdings and invest if you like their assets.

You don’t have to monitor your bonds. The ETF will do that for you.

Funds buy and sell bonds based on risk tolerance and the fund’s stated objectives.

ETFs provide a passive approach to bond investing. You can contribute any amount you desire and automatically reinvest the proceeds. 

Stay up to Date With Finances

Learning how to invest in bonds only represents the beginning of your journey. Strong financial habits will give you more proceeds to invest in vital assets. 

Mastering your finances early in life helps with retirement in the future. Your savings will compound as you earn and save more money.

Staying on top of the best news and tricks will help with your goals. Our magazine provides expert commentary and articles to help you master your money. Read through our issues today. 

Région Ile-de-France is the first European Sub-Sovereign to issue an ESG benchmark bond with a negative yield on the financial markets

In order to fund its annual investment programme, in particular its regional recovery plan (€6.8bn between 2020 and 2022), Région Ile-de-France issued a new €500mn public bond on 12 April 2021.

Région Ile-de-France becomes the first European Sub-Sovereign issuer to print an ESG benchmark bond with a negative yield (-0.12%).

Investors demonstrated a massive support for this transaction, despite a negative yield, highlighting their confidence into the Région Ile-de-France’s credit. Indeed, the issuance attracted up to €3.5bn of interests, i.e. 7 times the amount announced, with a total of 114 orders. As a reminder, the previous record for the Région was €1.3bn in 2018 (in comparison, the raised amount was also €500mn). This record is now exceeded by +€2.2bn.

The Région keeps on diversifying its investor base with 16 jurisdictions participating in this new transaction. France, Germany, Italy and Switzerland accounted for more than 60 % of the interests. The bonds were allocated to buy and hold investors committed to sustainable financing.

This strong success confirms the Région Ile-de-France’s position as a European leader in sustainable financing. Since 2019, the Région is committed to issuing 100% of its funding programme in sustainable format, representing 80 % of its outstanding debt versus 35 % in 2015.

This is the first transaction of the Région issued under its updated framework for Green, Social and Sustainable bond issuance, aligning with the European taxonomy. In its Second Party Opinion, Vigeo ranked the use of proceeds, the selection and evaluation process, as well as the management of funds as “best market practices”.

Région Ile-de-France is also the first European Sub-Sovereign issuer to have engaged in the alignment of its framework to the upcoming European standards, contributing to the success of the transaction.

Despite the Covid-19 related economic crisis, the Région’s financial ratios will stay on a more favorable track in 2021 compared to 2015. The current margin rate would stand at 32.1% in 2021 (vs. 20.5% in 2015). The self-financing capacity doubled compared to 2015.

At the end of 2021, the outstanding debt will be in line with the 2015 level. As a reminder, between 2004 and 2015, it increased by an average annual rate of + 10 %. At the end of 2021, the debt payback ratio should amount to c. 4.5 years, way below its late 2015 level (7.5 years).

Thanks to a tight operational expenditure control since 2016 (- €2bn in multi annual expenditures), the Région Ile-de-France was able to face the Covid-19 crisis with a solid financial position.

The Région has received the best rating possible at this time in France, in line with the Republic of France (Fitch “AA” and Moody’s “Aa2”). Fitch affirmed its rating on Friday 9 April, highlighting that: “Ile-de-France has tight control of expenditure, as reflected by a continuous decline in operating expenditure in the last years” […] “Ile-de-France’s liabilities carry little risk” […] “[its] debt payback ratio remained sound in 2020” […] “despite the impact of the pandemic” […] “In 2020, net adjusted debt declined for the third year in a row”

In March 2021, Région Ile-de-France received the Capital Finance International – CFI.co – « Best sustainability bond issuer – France » award.

The Dutch Fund for Climate and Development open for business

The Hague, November 15, 2019 – The Dutch Fund for Climate and Development (DFCD) has officially been launched in the presence of government officials, NGOs, investors, politicians and other interested parties. In May of this year, the DFCD was awarded to the consortium of Dutch development bank FMO, SNV Netherlands Development Organisation (SNV), World Wide Fund for Nature (WWF-NL) and Climate Fund Managers (CFM). “Today’s launch means that the DFCD is officially open for business,” said Linda Broekhuizen, Chief Investment Officer at FMO. “The consortium is keen to connect with innovative entrepreneurs with climate-related businesses and with private investors keen to mobilize much-needed funding from the private sector to join us in our mission to create a more climate-resilient world.”

Climate change is one of the biggest challenges we face today. It is already affecting people and nature across the globe, with developing countries being most impacted. “The poorest communities are the most vulnerable to climate change. Poor farmers and others at the bottom of the pyramid suffer and lose their livelihoods even with small changes in rainfall patterns or temperature”, as Meike van Ginneken, Chief Executive Officer at SNV explained.

There is an urgent need for investment to enable vulnerable communities and ecosystems to adapt to climate change. Carola van Rijnsoever, Director of Inclusive Green Growth, and Ambassador for Sustainable Development, Dutch Ministry of Foreign Affairs, said: „The challenge we face to help communities adapt to and mitigate the effects of climate change is enormous, and the case for action is incredibly clear. We cannot do this with governments alone. We need all stakeholders to be strong enough to confront this challenge. The set-up of this consortium in which finance and NGOs come together, is unique and uniquely positioned to do this.“ The government of The Netherlands has committed to addressing this need through the DFCD, making EUR 160 million available in the period 2019-2022 for climate adaptation and mitigation, of which at least 50% is earmarked for climate adaptation projects.

DFCD is a direct response to the increasing demand for climate adaptation projects that have to date suffered from a lack of funding compared with mitigation efforts. Linda Broekhuizen adds: “In 2018, USD 612 billion was invested in climate mitigation which is important and much needed. In contrast however, only 5%, USD 30 billion, was invested in adaptation. Adaptation may have to be USD 180 billion a year if the 2030 goal is to reach the USD 1.7 trillion as required according to the most recent report of the Global Commission on Adaptation.”

To help bridge this funding gap the DFCD aims to mobilize upwards of EUR 500 million from private sector investors. Andrew Johnstone, Chief Executive Officer of Climate Fund Managers adds: “The opportunities are there. Take water for example: 80% of the world’s wastewater enters rivers and oceans untreated and by 2025, half of the world’s population will be living in water stressed areas. Neither the private nor the public sector is doing enough, but together the investment potential is enormous, as is the impact to be delivered.”

This partnership of NGOs and financiers seeks to develop and finance sustainable private sector solutions to enhance resilience to the effects of climate change. These projects will boost the health of freshwater, forest, agricultural and ocean ecosystems, and improve water management.

“The consortium takes a landscape approach through investing in projects which are planned in an inclusive manner, and build on a solid understanding of the landscape, ecosystems and communities. In this way these projects will contribute to healthier ecosystems,” said Kirsten Schuijt, Chief Executive Officer of WWF-NL. “New and incredibly exciting in this consortium is that there is early-stage funding available to convert adaptation opportunities into bankable projects.” 

WWF and SNV take on the key role of developing climate-relevant projects from an early-stage idea to a bankable business case. Climate Fund Managers and FMO provide investment capital, delivering projects to full operations. This combination of early-stage involvement with full life-cycle funding will ensure lasting, long-term impact that contributes to the Paris Agreement and the United Nation’s Sustainable Development Goals (SDGs).

Interested parties can contact the DFCD through: www.thedfcd.com.

The Dutch Fund for Climate and Development open for business
In picture from left to right the DFCD partners at the official launch event in The Hague: Andrew Johnstone, CEO of Climate Fund Managers, Kirsten Schuijt, CEO of WWF-NL, Linda Broekhuizen, CIO of FMO, Albert Bokkestijn, project manger DFCD at SNV, Carola van Rijnsoever, Director of Inclusive Green Growth, and Ambassador for Sustainable Development, Dutch Ministry of Foreign Affairs.

In picture from left to right the DFCD partners at the official launch event in The Hague: Andrew Johnstone, CEO of Climate Fund Managers, Kirsten Schuijt, CEO of WWF-NL, Linda Broekhuizen, CIO of FMO, Albert Bokkestijn, project manger DFCD at SNV, Carola van Rijnsoever, Director Inclusive Green Growth, and Ambassador Sustainable Development, Dutch Ministry of Foreign Affairs.