Your 5-minute guide to the fundamentals of bond investing
In the world of investments, bonds are akin to the mythical genie in a bottle that can grant all our wishes and fetch us riches beyond our dreams. Who among us has not heard at least a few stories of people who invested in bonds (often with very limited funds) and achieved prosperity in just about a decade or so? Thus, most of us wish to invest in bonds (and wish to make bonds a big part of our investment portfolio). Yet, many of us are unable to do so due to lack of awareness. Hence, the world of bonds remains just out of our reach though it continues to beckon and tempt us.
If you are caught in this position, do not worry – help is at hand. In this brief article, we will quickly explain everything about investment in bonds. We will first look at what bonds are and understand why investing in bonds is so attractive. Then, we will look at the secrets of investing in bonds, bond investment strategies, what bonds to invest in, how to make the best investments in bonds, etc. – in short, everything about what bond investing entails. Thus, this article will fully empower you and enable you to invest in bonds.
What are Bonds – Why invest in Bonds
So, what exactly are bonds – apart from tempting investment avenues? A bond is essentially a lending instrument. Suppose you give a 2-year loan of $1,000 to the government of your country at an annual interest rate of 3%. In this case, initially, you would pay (or, in other words, you would give) $1,000 to the government. In turn, the government would give you a receipt specifying how much money it has received from you. After that, the government would pay you interest annually at 3% per annum on the $1,000. At the end of 2 years, the government would return the $1,000 borrowed from you. This is what happens when you buy a 2-year, 3%, $1,000 bond from the government – you lend $1,000 to the government for a period of 2 years at interest rate of 3% per annum. (Note that in this case, we would say that the period of maturity of the bond is 2 years.)
Bonds can be issued by the central government (i.e. union or federal government) or by counties/states or by cities/municipalities. Bonds can also be issued by corporate entities. In each case, the basic nature of the bond remains the same – buying a bond means lending some money to the issuer of the bond for a specific period of time at a predetermined rate of interest.
Bonds can offer a lot of security – bonds issued by the government, for example, are sometimes seen as some of the safest instruments to invest in (safer even than savings bank accounts in some cases). Similarly, short-term bonds (3 to 5 years’ duration) issued by blue-chip companies are generally considered very safe. Many (if not nearly all) bonds are rated by top-notch rating agencies. These ratings give you a very clear idea of how secure (how trustworthy) the bond is.
Bonds can also offer good returns – it is this combination of security and high returns that makes them so attractive as an investment option. Typically, bonds may carry higher interest rates than bank accounts, while possibly providing comparable security. Similarly, bonds with longer periods of maturity provide higher rate of interest. Corporate bonds generally carry higher rates of interest than government bonds. Some corporate bonds (called junk bonds) may even offer 30% to 40% annual rate of interest. But these bonds effectively provide no security and carry a high risk of default by the issuer (hence the expression junk bond).
Some bonds can also be traded in various markets. If you invest in such bonds, you need not keep your investment locked-in till the end of the period of maturity of the bond. Instead, you can sell your bond in the market at the prevailing price. The advantage of being able to trade a bond is that you can recover your money before the end of the period of maturity. Thus, you are free to invest your money in some other instrument at any point of time. This can be very useful if an entity offers a higher-yield bond (a bond with a higher rate of interest). You can sell off your lower-yielding bond and buy (invest in) the higher-yield bond.
Bond Investment Strategies
So, you have understood what bonds are and how they can be an excellent addition to your portfolio. You are tempted to start investing in bonds right away. Excellent! Before you start investing in bonds, let us understand some typical bond investment strategies.
One of the simplest strategies is to buy a bond and hold on to it till it matures (i.e. until its period of maturity ends and your invested money is returned to you. If you use this strategy, then your gain from the investment would be purely in the form of the interest paid by the issuer of the bond. Do remember (as we have seen earlier) that bonds with longer periods of maturity generally offer higher rates of interest. Similarly, corporate bonds generally offer higher rates of interest than government bonds. Also, riskier bonds offer higher rates of interest. If you want to be very conservative (cautious) in your investment, then you may want to avoid excessively risky bonds altogether. In such a case, you should focus purely on government bonds and top-rated bonds issued by blue-chip corporates. If you are willing to take more risk, then you can consider investing some of your money in riskier high-yield bonds.
Instead of buying individual bonds, you may also consider investing in various funds that invest in a mix of bonds. Some such funds invest purely in a mix of bonds while others invest in a mix of bonds as well as other instruments (such as shares, etc.). Different funds have different objectives (targets) and thus, it is relatively easy to find funds that match your investment goals. Some funds invest purely in the most secure government and corporate bonds. Others may invest a small percentage of their funds in riskier high-yield bonds while some funds may invest the bulk of their funds in riskier bonds. You could choose to identify one (or a few) of the best performing funds that match your investment goals and invest in those. Or, you could even invest in a mix of different types of funds. The advantage of investing in funds is that you do not need to constantly search the market for various bonds on offer, analyze them and then take an investment decision – instead, the professionally managed fund would undertake these activities.
Finally, you need not always hold on to a bond till it matures. As we saw earlier, you can sell some bonds before they mature. When you sell a bond, you may make a gain (or loss) on the sale of the bond. Suppose you buy a 5-year, 7%, $1,000 bond. At some point of time (say, 2 years and 4 months later), the bond may be selling for $1,050 in the market. In such a case, selling the bond would fetch you a profit of $50. (Additionally, you would also have received the interest pay-out for the first two years.) Similarly, if the bond is priced at $950 in the market, selling it would result in a loss of $50. Selling bonds before they mature can be very useful if you want to have the freedom to get your invested sum back at any point of time. It can also provide an additional source of profit (over and above the interest that your bond fetches).
With this, you are now ready to invest in bonds. You have understood what bonds are and how they can be very attractive investment instruments. You have also understood the common bond investment strategies and understood how to make profits through investing in bonds. You now hold the power to tame and conquer the world of bonds.