How to invest in bonds? Most of us are used to borrowing money at some point in our lives, whether it’s asking for credit to buy our house or for some personal project. Likewise, companies, and the state also borrow money. When? In the issuing period
How obligations work
Bonds are a way for an organization to raise money. Let’s say your city asks for a certain investment of money. In return, your city promises to pay back this investment, plus interest, for a specified period.
For example, the investor can buy a 10-year bond and $10,000 with 3% interest. In return, your city promises to pay interest on that $10,000 every six months and then return your $10,000 after 10 years.
How to earn money with bonds
There are two ways to make money investing in bonds. The first is to keep these bonds until their maturity date and charge interest on them. The interest on the bonds is usually paid twice a year.
The second way to profit from bonds is to sell them at a higher price than the investor pays initially.
For example, if the investor buys $10,000 in bonds at face value – meaning he paid $10,000 – and then sells them for $11,000 when their market value increases, the investor can pocket the difference of $1,000.
Bond prices can rise for two main reasons. If the borrower’s credit risk profile improves so that the investor is more likely to pay the bond at maturity, the bond price will usually increase. In addition, if prevailing interest rates on newly issued bonds fall, the value of an existing bond at a higher rate will increase.
Investing in Bond Funds
Bond funds take money from many different investors and pool everything so that a fund manager can handle it. Usually, this means that the fund manager uses the money to buy a wide variety of individual bonds. Investing in bond funds is even safer than having individual bonds.
Types of Bonds
Obligations come in a variety of forms, each with its own set of benefits and disadvantages.
Corporate bonds – They tend to offer higher interest rates than other types of bonds, but the companies that issue them are more likely to default than government entities.
Treasury Bonds – They are issued by governments. Due to the lack of market risk, interest rates will be lower than corporate bonds.
How to buy bonds
Unlike stocks, most bonds are not publicly traded, but are traded over the counter, which means that the investor must use a broker. Treasury bonds, however, are an exception – the investor can buy them directly from the government without going through an intermediary.
The problem with this system is that since bond transactions do not take place in a centralized location, investors have more difficulty knowing whether they are getting a fair price. A broker, for example, may sell a particular bond with a premium (i.e. above its nominal value).
Benefits of investing in bonds
Security – An advantage of purchasing bonds is that they are a relatively safe investment. Bond values do not tend to fluctuate as much as stock prices.
Income – Another benefit of bonds is that they offer a predictable income stream, paying the investor a fixed amount of interest twice a year.
Community – By investing in a municipal bond, the investor can help improve a local school system, build a hospital, or develop a public garden.
Diversification – Perhaps the greatest benefit of investing in bonds is the diversification they bring to your portfolio. In the long run, stocks outperform bonds, but the combination of both reduces financial risk.
Disadvantages of investing in bonds
Less money – bonds require investors to block their money for long periods of time.
Interest rate risk – As bonds are a relatively long term investment, the investor runs the risk of changes in interest rates. For example, if the investor buys a 10-year bond paying 3% interest and one month later, the same issuer offers bonds with 4% interest, then their value will fall in value. If the investor holds it, he will lose potential gains by being stuck at that lower rate.
Issuer Risk – This is unusual, but if an issuer does not meet its obligations, the investor runs the risk of losing interest payments, receiving repayment of the principal or both.
Transparency – There is less transparency in the bond market than in the stock market, so sometimes brokers may charge higher prices and the investor may have more difficulty in determining whether the quoted price for a particular bond is fair.
Lower returns – the return on investment that the investor obtains with bonds is substantially lower than that obtained with stocks.
Anyone should invest in bonds ?
The only person who can answer that question is the investor. Here are some scenarios to consider when deciding:
If you are a risk-averse investor and really can’t stand the idea of losing money, bonds can be a more suitable investment for the investor than stocks.
If the investor invests heavily in stocks, bonds are a good way to diversify your portfolio and protect yourself from market volatility.
Most people are advised to leave the stocks and go to the bonds as they get older, and it’s not a bad advice, as long as you don’t make the mistake of completely discarding your shares in retirement.