Bonds are popular investment vehicles around the world. According to official statistics, the amount of outstanding bonds around the world is more than $100 trillion. This amount is much higher than the market value of all stocks in the world, which are valued at more than $60 trillion. While bonds are popular, very few investors have a good understanding about the asset class. This article will explain what are bonds, examples of bonds, whether you can lose money in bonds, and whether it is safe investing in bonds.
What are Bonds?
Large institutions and governments are in constant need of money. They need the funds to pay salaries, invest in R&D, and fund for infrastructure among other things. These institutions can get this funding from their operations. For example, a government can get the funds to pay salaries from their operations.
However, this is usually not the best way to do things. For example, a government might not have enough cash at hand to fund these projects. As such, another option is usually to raise debt from organizations like banks. Still, these are usually not good options because of the high interest rates.
Bonds are great alternatives for large companies, municipals, and countries to raise money. A bond is simply a loan that these institutions take from multiple investors. Unlike stocks, bond holders do not have any stake in a company or government.
Like what happens in the stock market, there are a number of terminologies that you need to understand when investing in bonds. Here are some of the best bond terminologies you need to know.
- Par Value. This is the face value of a bond. This is simply the amount of money that is returned to investors after the bond matures.
- Coupon Interest Rate. This is the interest rate that the bond issuer promises to pay the bond holder.
- Maturity. This is the period in which the bond comes due. A bond maturity can range from 1 year to more than 30 years.
- Bid price. This is the highest amount of money that buyers are willing to pay for the bonds.
- Ask price. This is the lowest price offered by the sellers.
- Basis points. This is one hundredth of a percentage.
- Rating. Every bond is usually rated by a credit rating agency. High credit rating results to a lower interest rate.
- Yield. This is the effective return that the investor will make on the bond.
Bonds vs Stocks. What is the Difference?
While bonds and stocks are popular ways of raising money by companies, the two are very different. They are like left and right. Here are some of the differences between bonds and stocks.
- Stocks are usually for companies only while bonds are issued by many entities like governments and municipals.
- Stock holders own part of the company. This means that they can be involved in making decisions about a company. Bond holders are merely creditors who can’t get involved.
- Bonds have a maturity while stocks can be owned forever.
- Bonds have mandatory payments, which are made periodically. Stocks don’t have a mandatory payment to shareholders.
Types of Bonds
Like with stocks, there are a number of types of bonds. The most popular types are:
- Treasury bonds. These are bonds that are issued by the central bank. The Federal Reserve is one of the biggest issuers of treasury bonds.
- Investment-grade corporate bonds. These are high-quality bonds that are issued by stable companies like Microsoft and Apple.
- High-yield corporate bonds. These are bonds that are issued by low quality companies. They are also known as junk bonds.
- Mortgage-backed bonds. These are bonds that are backed by mortgages.
- Municipal bonds. These are bonds that are issued by municipal councils to fund development.
- Plain vanilla bond. This is a bond that has no unique features. Most bonds are plain vanillas.
- Floating rate bonds. These are bonds that have a coupon that is not fixed. Instead, it is usually linked to a benchmark like the treasury bond.
- Convertible bonds. These are bonds that have a unique attribute in that they can be converted into stocks.
How to Invest in Bonds
Like in stocks, there are a few things you need to do when you want to invest in bonds. First, you need to find a brokerage that accepts bonds investing. In the US, the most popular brokers that offer bond trading are:
While Robinhood is a popular brokerage, it does not offer bonds. Second, you need to research about the bonds. A good way to get started is to read investment research about bonds from platforms like Seeking Alpha. You also need to view the various ratings offered by Morningstar, which is the leading platform for bond ratings. After finding the bonds you like, you should go ahead and invest in them.
Can I Lose Money Investing in Bonds?
While bonds are usually relatively safe investments, it is usually possible to lose money when investing in bonds. There are a number of scenarios where you can lose money investing in bonds. For example, when a company you have invested in goes bankrupt, you lose your money. However, in terms of liquidation, bond holders usually have the first priority. There are a number of examples when bond holders have lost money. For example, when Sears went bankrupt and when Puerto Rico defaulted on its obligations. In this regard, there are a number of risks that comes with investing in bonds.
Risks of Investing in Bonds
As mentioned, investing in bonds has some risks. Here are some of the most common risks associated with investing in bonds.
- Credit risk. There is always a risk that a creditor will default on their obligations. This is what happened with the bonds issued by Puerto Rico.
- Inflation risk. Inflation usually reduces the purchasing power of a bond’s future coupon. Therefore, when inflation rises a lot, there is a risk that the value of the coupon will not be very useful.
- Interest rates risk. High interest rates are usually risky for bond investors. Generally, rising interest rates usually lead to falling bond prices and vice versa. As such, lower interest rates lead to rising bond prices and lower yields.
- Reinvestment risk. When interest rates decline, investors have to reinvest their coupon income and their principal at maturity at lower rates.
- Liquidity risk. Unlike stocks, the bond market is usually not very liquid. This may make it difficult for you to find buyers when you want to exit.
Bonds are the largest asset class around the world yet very few people know about them. This is because many people tend to focus on stocks. As a long-term investor, we recommend that you incorporate bonds in your investment strategy. This will help you diversify your portfolio.
Kasper is our expert for saving, investing and bank accounts. Kasper holds an MSc in Mathematics and worked with Mercedes-Benz and the Dutch tax authorities.