As an investor, you have many different opportunities to consider, and the option to invest in bonds is a common choice. As part of our series on investing for beginners, we will take a look at what is a bonds, different types of bonds, risks of the bond market, and how to invest in them. In this article, we will cover:
- What is a bond?
- Types of bonds
- What is the bond market and how to invest in bonds?
- What are the benefits and risks of bonds?
- How should I interpret credit ratings?
- How can you achieve a return with bonds?
- How are bonds influenced by today’s ultra-low interest rates?
- How can I set up a portfolio with bonds?
Okay, let’s get started.
What is a bond?
When you purchase stocks, you are purchasing a small piece of a company. With bonds, you essentially are lending money to a company, government or organization that will repay their debt plus interest.
A bond is known as a negotiable debt security where a stock would be known as an equity security. A company, a government or an organization that borrows money issues a debt security in exchange: the bond. The lender can decide to sell the debt security to a third party who acquires the right to the interest payment and principal invested.
Most bonds have fixed interest, which is known as the coupon. The majority of bonds have a specific term after which the principal must be repaid. There are short-term bonds, which typically must be repaid in five years or less; intermediate-term bonds, which usually must be repaid in 5-12 years; and long-term bonds, which can include terms up to 30 years or more.
Types of bonds
There are several different types of bonds that you can purchase, including:
These are, as the name suggests, bonds issued by a government. For instance, the United States government issues Treasury bonds, which mature in 10 to 30 years . Government bonds tend to be the safest type of bonds, as they are backed by the government. Of course, some governments are more stable than others, so bonds in emerging and frontier markets may be riskier than bonds in mature markets such as the United States, Japan and the United Kingdom.
This is simply a debt security issued by a company. When a company needs funds, or capital, it might issue bonds. The risk associated with corporate bonds depends upon the overall health of the company, which is generally referred to as its bond rating, which we will talk about later in this article.
These are bonds that are secured by real estate holdings. Because the bond issuer has the option to sell the property or real estate if needed, the risk of these types of bonds can be lower than that of corporate bonds. Of course, when there is lower risk, usually the yields are lower, as well. Additionally, as we all remember, mortgage bonds weren’t a particularly safe bet during the housing crisis of 2008, when many bonds were backed by high-risk mortgages, known as subprime mortgages.
What is the bond market and how to invest in bonds?
Investors can take advantage of opportunities in the stock market or the bond market, and these markets are simply where bonds and stocks are sold or issued. With the stock market, there are several exchanges where stocks are bought or sold, such as the New York Stock Exchange, the American Stock Exchange, Nasdaq and more.
When it comes to bonds, the bond market is the marketplace where one goes to buy debt securities. Typically, investors either work with a broker or with an online brokerage firm to purchase bonds. In general, if you purchase bonds, you must purchase them with a high minimum investment, which can keep some investors away.
However, if you purchase bonds through a mutual fund or an ETF (exchange-traded fund), you can buy them also for a smaller amount. Additionally, there will be several bonds in the fund or ETF, diversifying the investment, which means it has relatively lower risk than purchasing bonds issued by just one entity.
What are the benefits and risks of bonds?
In general, the most important advantage of bonds is that they are relatively less risky than shares (stocks). In case of bankruptcy, a company must first repay bondholders and creditors and only then repay shareholders.
Of course, this lower risk also has a disadvantage: the risk premium linked to bonds is lower, which causes their expected return to be lower than that of shares over the long term. This means that if a company does well, the returns you enjoy with bonds probably aren’t going to be as high as the returns from shares. Bonds pay a set interest rate, while the value of shares grows as the value of a company grows.
The most important risks of bonds are as follows:
This is the risk that the issuer does not repay (a portion of) the principal invested and/or pay the coupons (interest payments). It is often said that government bonds have a lower credit risk than corporate bonds. This is because a government can increase its taxes if it needs more money. However, plenty of examples also can be found in the past when governments did not (completely) repay their bonds. This risk is significantly higher in emerging markets.
Interest rate risk
This is the risk that the value of the bond declines when market interest rates increase. The value of a bond with a fixed coupon (the fixed interest rate) moves in the opposite direction from interest rates. The reason is that when the market interest rate increases, investors can obtain a new bond with a higher coupon. This automatically reduces the value of the bonds already issued with a lower coupon. Conversely, the value of a fixed-income bond increases when market interest rates drop.
Source: VanEck. The figure only considers the impact of market interest rate levels on the bond price and does not take into account other criteria that could potentially negatively influence the bond price.
Let’s consider a simple example. Perhaps you purchase a bond with 1% interest rate and let’s say that interest rate is in line with current market interest rates. If the market interest rates increase to 1.5%, then people will be able to purchase bonds with a 1.5% rate of interest. Those bonds, once they reach maturity, will pay out more than your bond, simply because interest rates increased. While the bond market is a bit more complicated than this example, this expresses, in basic terms, how interest rates may affect your investment value.
Investors buying bonds that are issued in a foreign currency take currency risk. Suppose you invest in a bond denominated in dollars and the euro increases in value relative to the dollar. In that case, the value of your investment, stated in euros, drops. Of course, this risk works in two ways. If the euro were to drop, the value of your dollar-denominated bond increases.
How should I interpret credit ratings?
To help investors make the best decisions for their portfolios, bonds are rated by credit agencies such as Standard and Poor’s, Fitch, and Moody’s. These companies provide an estimate of the credit risk of some bonds. They summarize it in a score: AAA has the highest credit rating. C and D the lowest (these are often called junk bonds). But watch out: in the past, companies with high credit ratings have gone bankrupt. Thus, credit bureaus do not have a monopoly on the truth!
||Minimal credit risk
|Very low credit risk
|Low credit risk
|Moderate credit risk
|Substantial credit risk
|High credit risk
|Very high credit risk
||In or near default, with a chance of getting part of the loan back
||In or near default, with little chance of getting back part of the loan
How can you achieve a return with bonds?
There are two ways that you can achieve a return on bonds:
This is the return that is obtained from the periodic interest payments.
This is the return that is obtained when the market value of the bond increases. Reasons for this can be:
- Reduced credit risk of the issuer. For instance due to an improved economy, operational improvements at the issuer, or because the bond is coming to the end of its term, meaning the chance of bankruptcy is reduced.
- Falling market interest rates.
Note: As discussed above, the price return also can be negative. For instance, if the credit risk increases or interest rates increase, the price return could be negative.
Source: VanEck. The figure only considers the factors interest rates, price level and bond yields and does not take into account other criteria that could potentially negatively influence the bond price.
How are bonds influenced by today’s ultra-low interest rates?
Let’s face it, these are unprecedented times for bond investors. Government bonds denominated in euros with a credit rating of AAA and a term up to 25 years have a negative interest rate.
Yield of EUR government bonds with an AAA credit rating
Source: ECB Europe. As of 30 September 2020.
This means that you have to add money if you want to hold on to a high-grade euro government bond until the end of its term! Incidentally, this does not, per se, mean that you will suffer a loss. You would be able to make a price gain if market interest rates drop further and you sell the bond before the end of its term.
Corporate bonds also are influenced by today’s ultra-low interest rates. Very solvent companies such as Sanofi also have a negative interest rate on certain bonds (information as of 26 November 2021).
The place where you can achieve even higher returns is in emerging markets. Of course, this is balanced by an increased credit risk, and you generally also will run a currency risk. Emerging markets include countries such as Mexico, Russia, China, Brazil, India, Turkey and Indonesia.
How can I set up a portfolio with bonds?
If you want to reduce the risk in your investment portfolio, you could consider investing a portion of your portfolio in bonds. You could consider diversifying your bond allocation across government bonds and corporate bonds, and both across different regions.
VanEck offers bonds in the following categories: