Updated on July 23, 2024
March 15, 2022
If you are looking for an alternative to trading stocks, bonds could be the right choice for you. Investing in bonds is safer than stocks. Therefore, it could be an ideal tool to spread the risk of your portfolio. In this article, you will learn everything you need to start investing in bonds. We will explain to you who the bond issuer can be and when the bonds are issued. And you will learn, among other things, everything about what bonds yield, what their maturity is, as well as what bond mutual funds are.
What is a bond?
A bond is a security that can be traded on the stock exchange, over the counter, or privately. Bonds are similar to stocks in many ways. For example, with why the issuer decided to marry them. Bonds are issued when a company needs capital. Whether it is the initial expenses that a newly established company needs to cover, or the expenses of already established corporations. It can be financial resources connected to the fulfillment of obligations it has towards other companies, or also expenses for the expansion of the company. In the best case.
Therefore, if the issuer needs to obtain financing in a different way than from a bank, it will issue bonds. These usually have a face value of US$1,000. And it is this amount that the future owner of the bond will provide to the issuer, i.e. the issuer of the bond. He can do whatever he wants with her. But bondholders understandably don’t just donate their money to companies. On the contrary. He becomes a creditor of the given company.
The issuer must therefore ensure that it regularly repays its debt to the creditor. It is usually repaid gradually at quarterly intervals. The interest that accrues from such a loan is also added to this amount. Therefore, when you, as a creditor, procure a bond, you will have an indication in advance when the amount provided by you is due. In addition, the interest rates and terms of the loan are also listed here. The amount of these interests then depends on the type of bond.
Bonds and stocks
If the company wants to get financing in a way other than a bank loan, it will have to choose between two options. It can issue either stocks or bonds. In addition to similarities, there are also fundamental differences between these two tradable assets that separate them. They bring advantages to both parties on the one hand, and disadvantages on the other. So each has something in it for both issuers and investors in bonds.
When the issuer decides whether to issue bonds or shares, he will certainly think about what will be more beneficial for him. If the company decides to issue shares, it will have to take into account that it is a type of security where the investor gets a certain share in the company. This means that corporations must be content with investors gaining the right to vote on the board of directors and thereby influence the direction the company will take.
On the other hand, they can decide what dividends to pay. And whether they will pay them at all. For example, it is common for newly established companies not to pay dividends. They need their profits to invest in initial expenses. Furthermore, of course, it also depends on whether it will be value or dividend shares. In the case of a bond, however, it is stipulated in advance that the company must repay the given amount with interest. He is in the position of debtor.
Investing in bonds or stocks?
For the investor, the bond is a safer investment. Precisely because the amount he provided to the company must be repaid by a certain date. And it is a more reliable investment even in case the issuer finds itself in liquidation. Unlike a shareholder, a bond investor is considered a creditor. In the event of liquidation, he will be among the first in line to repay the debt. On the contrary, shareholders will be among the last to receive their payouts.
Of course, this reliable trading has its drawbacks. Especially if you are not well versed in the world of bonds and trading. Investing in bonds also requires careful preparation. Do your due diligence on the issuer. That is, the issuer of the bond you are interested in. That way, you can better avoid that it ends up in liquidation. Even though the bondholders have priority in repayment as creditors, the remaining capital of the company matters. And so it could happen that you will never see your savings again. And therefore not even the income that flows from holding the bond.
Bond rating
When choosing which bond is worth investing in, some rating agencies can help you. They evaluate bonds according to how safe an investment it is. Such agencies include, for example, Standard & Poor’s and Moody’s. To orient yourself in this rating, know that the highest rated bonds are designated as AAA. Conversely, bonds that have been evaluated as the least safe are marked with the letters C or D.
The amount of interest then also depends on this assessment. And the resulting income for the bond holder. Issuers of bonds that are rated worse pay higher interest. This is due to the fact that such bonds are considered risky. It is therefore not absolutely certain whether the issuer will be able to repay its loan. Expect higher interest even if you hold a bond that will have a very long maturity. Why? Simply because the lender will be exposed for a longer period of time to factors that could reduce their yield. These include, for example, inflation and the market interest rate.
Important terms for investing in bonds
In order for your bond investment to give you the return you envision, you should be familiar with basic bond terminology. So let’s take a look at a few terms that you shouldn’t miss when trading bonds.
Issue rate
When we talk about the issue price, we mean the original price at which the issuer originally sold its bonds.
Principal
The amount that the investor initially provides to the issuer of the bond is called the principal. The issuer of the bond subsequently has to repay this together with interest to the investor. These interest rates are called coupons. The yield you can get from the given bond depends on the amount of the coupons.
Nominal value
The nominal value is usually higher than the issue price. It is the total amount of money that bond owners are to receive at maturity. That is, the principal together with the returns.
Due date
The maturity date is the date by which the issuer must pay its creditor the full nominal amount. That is, the principal and the coupon.
Coupon rate
The coupon rate is expressed as a percentage and is calculated from the nominal price. Simply put, it indicates the annual interest rate. We can therefore calculate from it how much the lender will get from the issuer annually through coupons.
Prospectus
If the issuer wants to publicly offer its bonds, it must publish a prospectus with each bond issue. It should contain basic information. These include the bond’s face value, maturity date, and coupon rate. In addition, there should be information on the financial situation of the bond issuer. Based on this, as an investor, you can get a picture of whether or not a specific investment will pay off for you. This means how high the chance is that he will receive the principal and his income from the issuer of the bond on the maturity date.
There are two options for a bond issuer to avoid the need to publish an approved prospectus. The first is that it will not offer its bonds publicly. In that case, it is private bond trading. In the second case, these are sub-limit bonds. Specifically, this means the issue of bonds, the volume of which does not exceed one million US dollars.
Get smarter with such bonds. Since the prospectus will not help you make your own judgment about the safety of such an investment, do your own research. You should know who you are entrusting your savings to. That is, on the assumption that you want to wait for the full repayment with interest on the bond’s maturity date.
What are bonds?
There are many types of bonds and we can distinguish them based on various indicators. We will now look at their distribution by issuer, interest rate and bond maturity.
Types of bonds by issuer
Several institutions can decide to issue bonds. So it is not just a reservation of corporations. It can also be states, state organizations and municipalities. And with different maturity periods.
Corporate bonds
We probably most often come across bonds issued by corporations. These are private companies whose management decides not to use the services of any bank. At the same time, for some reason, he refuses to issue shares, and instead decides on bonds. He usually opts for bonds rather than a bank loan. And that’s because issuing bonds offers more favorable conditions than banks. If a company prefers bonds to stocks, it may be because they do not want to allow shareholders to share in the company’s future.
We can also include bank bond issues in this category. Yes, banks also issue bonds. And usually these securities are among the safest bond investments. And that’s because banks tend to be financially healthy companies. Bonds issued by banks also include mortgage bonds. They are issued by banks in case they need to finance a certain part of mortgages.
State bonds
The state government can also decide to issue bonds. This is in the event that he needs to somehow secure his finances and manage them. In the Czech Republic, these issues are ensured by the Ministry of Finance of the Czech Republic. The amount that the government undertakes to repay to its creditors is subsequently included in the national debt. States issue bonds with different maturities.
This type of investment in bonds is also considered very safe. Of course, it depends on who is their issuer. Make sure you have a high credit rating first. And also get well informed about whether the state issuing the bonds has economic stability and also a politically stable environment. Otherwise, your investment might not pay off. Thus, you would not have to wait until the maturity date of the bond, not only for the principal, but also for the coupon.
You can also buy bonds from countries other than the one you are a citizen of. With exceptions. In the Czech Republic, Dluhopysy Republiky is an example of such bonds. The government decided to issue them on the occasion of the anniversary of the establishment of the Czechoslovak Republic. These bonds belong to the category of savings bonds. These are intended exclusively for Czech citizens.
Agency bonds
Agency bonds are issued by state-owned enterprises. For example, in the USA, an example of an issuer of such bonds can be Freddie Mac. It is a state organization that was created to ensure stability and availability in the mortgage market.
Municipal bonds
Others, which can issue bonds, are territorial self-governing units. They issue municipal bonds.
Types of bonds according to interest rate
Not all bonds earn the same interest. Based on the type of coupon the bond uses, we distinguish several types of bonds.
Fixed interest bonds
This type of bond has a fixed coupon for its entire lifetime. It should therefore be very clear to you what your return will be if you decide to invest in this type of bond. However, the amount of the resulting yield from holding the bond is affected by inflation and interest rate changes.
Bonds with variable interest
Interest on such bonds is tied to a certain reference rate. It can be, for example, the interbank rate PRIBOR , LIBOR, or some other. A surcharge is also calculated for the yield, which is based on a higher risk than is the case with the previous type of bond.
Indexed bonds
For these bonds, the interest is tied to some other asset. For example, on the development of the index of gold, oil, or perhaps wages.
Bonds with zero interest
Bonds with zero interest may seem disadvantageous at first glance. After all, no investor would lend to a bond issuer without being sure that he would get some personal benefit from his loan. Or yes? But the investor also has a certain yield from a bond with zero interest. Investors buy such bonds below the nominal price. That is, with a discount. The bond issuer then pays the creditor the entire nominal value of the bond.
Types of bonds by maturity
The maturity period also differs for individual bonds. On this basis, we distinguish between short-term bonds, medium-term bonds and long-term bonds. As already mentioned, the owner of a bond with a very long maturity is promised a higher coupon.
Short-term bonds
The maturity of such bonds is within one year. We can include here, for example, treasury bills. The issuer of these bonds is the state.
Medium term bonds
These are bonds with maturities ranging from one year to ten years.
Long-term bonds
Long-term bonds are due in more than ten years.
Bond trading
If you’re interested in investing in bonds, there’s one last thing left to do. And that is to learn how bonds can be traded. You can do so on the primary or secondary bond market. The primary bond market means that the bond issuer sells them directly to investors. This can take place, for example, through an auction.
In the secondary bond market, these bonds are already traded by the investors themselves. This can take place either on the stock exchange, where the rules under which these bond trades take place are precisely defined. The second option is over-the-counter markets, also called OTC markets. Brokers, large banks and various funds deal with each other here. They negotiate the terms of bond deals for themselves or their clients.
The procedure described above applies to the trading of physical bonds. However, there are other ways to invest in bonds. These include bond fund trading, bond ETF investing and bond CFD trading. We will now look at these ways of investing in bonds.
Bond funds
Bond funds are mutual funds, the purchase of which will invest in bonds. Mutual fund trading is ideal for beginners. The risk is spread here. At the same time, it is also an ideal way to diversify the portfolio of more experienced investors.
Bond ETFs
When you trade bond ETFs, you’ll be investing in a “basket” of bonds. Similar to bond funds, investors’ risk will be spread. However, unlike bond funds, they are traded on the stock exchange. At the same time, there is a difference in the frequency of their trades. While bond funds trade once a day, the price of bond ETFs changes throughout the day. The reason is precisely that bond ETFs are traded on the stock exchange. The price of the underlying bonds therefore changes depending on supply and demand.
CFD investments in bonds
CFD investments in bonds have their specifics. They are offered, for example, by various online brokers. In this case, you are not trading physical bonds. On the contrary, you are only estimating how the price of the given bond will develop. The specific bond therefore figures here only as an underlying asset. By trading bond CFDs you are not buying a real bond. Just contract with your broker. You both agree to pay the difference between the purchase price and the sale price. So if you estimate the development of the bond price correctly, you make money. If wrong, you lose.
The advantage of this type of bond trading is that you can also speculate on a drop in the bond’s price. Not only for her growth. The advantage and at the same time the disadvantage of this type of trading is the leverage effect. This means that you do not need to own funds corresponding to the total volume of the bond purchase. Only a certain percentage is enough. The rest is financed by the broker. Subsequently, your income will multiply. But pay attention to the fact that the same applies to loss. So beware of this risk.
Bonds – yes or no?
To summarize, bond trading is considered one of the safest investments. In particular, bonds issued by banks, economically and politically stable states and corporations. Finally, you can judge the level of risk based on the prospectus.
If you cannot find the prospectus for the given bond, it is a good idea to study your future lender yourself. Especially his financial situation. This can prevent you from seeing your money invested in the bond or the interest on the bond’s maturity date. Bond funds and bond ETFs are also considered safe to trade.
