You’ve probably heard the term before. Perhaps you know a friend or family member who invested in bonds and they were happy with their returns. But if you’re anything like most people, you probably don’t really know what bonds are, let alone how to invest in them yourself. That is why we have written this guide to investing in bonds.
It is a beginner’s introduction to bonds that explains everything you need to know about this investment opportunity and whether it could be right for you as an investor.
What is a bond?
A bond is a type of debt security. In the simplest terms, it is a form of loaning money to an organization, be it a government or a corporation. There are many reasons why a company or government may want to borrow money from the public and there are several different types of bonds. These will be covered more in the next section.
Bonds work by enabling the organization that has issued the bonds to receive funds in order to finance some sort of long-term project that requires a significant amount of capital. In exchange for loaning the organization money, you will receive a fixed interest rate over a set period of time.
That interest is paid at regular intervals, and at the end of the bonds’ term, you will typically be paid back whatever you initially invested in the bonds. This repayment process is commonly called the “maturity date.”
How do you invest in bonds?
This is where things start to get interesting. Whereas most investments are about the potential for growth, bonds are about the potential for loss. If you purchase a bond, you are essentially lending money to the issuer. The bond issuer will promise to repay you your original investment (the principal) plus interest at a specific future time. Bond investments are typically made in fixed-income securities. When you buy a bond, you are loaning the issuer a specific amount of money for a set period of time. The issuer is obligated to repay the loan along with interest at the end of the term.
Bond investment types
There are a number of different types of bonds, each with its own risk and return characteristics. Typically, there are two main types of bonds – government (or sovereign) and corporate. Government bonds – The main advantage of investing in government bonds is that they are relatively low risk, which means they offer a low rate of return.
Corporate bonds – These are associated with more risk and therefore a higher return. Within these two categories, there are a number of sub-categories that vary based on their specific characteristics. For example, some bonds have “call features” that allow the issuer to repurchase the bonds from you at a specified price, usually due to changing economic conditions or other reasons.
Benefits of investing in bonds
– Guaranteed returns – When you invest in bonds, you know exactly how much you will receive at the end of the term. Unlike investing in stocks, where there is always a chance you could lose money, with bonds you are guaranteed to get your initial investment back, plus interest.
– No need for active trading – While stocks are traditionally viewed as long-term investments with average holding periods of 10 years or more, the fact that bonds are a lower-risk asset means that you don’t have to trade them as often and can hold them for a much longer period of time.
– Less risk than stocks – Since bonds are a less risky investment than stocks, they are usually a good choice for investors who are trying to minimize their risk.
Risks of investing in bonds
– Interest rate risk – Although most investors understand that bonds are a less risky investment than stocks, they often don’t realize that there is also some risk of their value decreasing over time. This is because the price of the bond (i.e. the amount you initially pay for it) is determined by the interest rate. If interest rates go up, the price of existing bonds will decrease in value.
– Inflation risk – Another factor to consider is inflation. While low-interest rates are often seen as a good thing for investors, when interest rates are low it may also mean that there is little inflation.
This means that the purchasing power of your money stays the same or decreases over time when you’ve invested in low-interest bonds.
– Redemption risk – The bond issuer could suddenly declare bankruptcy, defaulting on the loan. If this happens, you’re unlikely to ever get your money back.
– Liquidity risk – This refers to the ease with which you can convert your bonds into cash. While you will receive your initial investment back at the end of the term, you may only be able to sell the bond at a discounted price.
All in all, investing in bonds is a relatively low-risk investment option that is suitable for most investors. While it is unlikely to deliver the same level of returns as stocks, it is less risky and therefore is a good option for people who want to minimize their risk.
That being said, given the current low level of interest rates, bonds are likely to be less attractive to investors than they have been in the past. This means that it is important to understand how investing in bonds works and how different types of bonds can affect your portfolio. If you want to earn a steady income from your investments and minimize your risk, bonds could be a good choice for you.