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:
Okay, let’s get started.
When you purchase stocks, you are purchasing a small piece of a company. When you invest in bonds, you essentially are lending money to a company, government or organization that will repay their debt plus interest.
Source: VanEck.
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.
There are several different ways you can invest in bonds, including:
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 invest in 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.
In general, the most important advantage of investing in 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.
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!
| Rating | Fitch | S&P | Moody's | Description (Moody's) |
| Investment grade | AAA | AAA | Aaa | Minimal credit risk |
| AA+ AA AA- |
AA+ AA AA- |
Aa1 Aa2 Aa3 |
Very low credit risk | |
| A+ A A- |
A+ A A- |
A1 A2 A3 |
Low credit risk | |
| BBB+ BBB BBB- |
BBB+ BBB BBB- |
Baa1 Baa2 Baa3 |
Moderate credit risk | |
| Sub-investment grade | BB+ BB BB- |
BB+ BB BB- |
Ba1 Ba2 Ba3 |
Substantial credit risk |
| B+ B B- |
B+ B B- |
B1 B2 B3 |
High credit risk | |
| CCC+ CCC CCC- |
CCC+ CCC CCC- |
Caa1 Caa2 Caa3 |
Very high credit risk | |
| CC C |
CC C |
Ca | In or near default, with a chance of getting part of the loan back | |
| DDD DD D |
SD D |
C | In or near default, with little chance of getting back part of the loan |
There are two ways that you can achieve a return investing in 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:
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.
Interest rates are often measured along a so-called "yield curve". This shows the interest for different maturities.
Yield of EUR government bonds with an AAA credit rating
Source: VanEck.
In general, interest rates with shorter maturities are lower because they involve less credit risk for the lending party. However, this is not always the case. In the past, periods when short-term rates were higher than long-term rates were sometimes followed by recessions.
Corporate bonds also are influenced by today’s interest rates. Very solvent companies such as Novartis still have a relatively low interest rate on certain bonds (information as of 22 November 2022).
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.
If you want to reduce the risk in your investment portfolio, you could consider investing in bonds a portion of your portfolio . 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:
