Category: 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.

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.