Before we answer the question of whether bonds are good investments, let’s first explain a little bit about them. Bonds, usually referred to as fixed income instruments, are used by governments and corporations to borrow money from investors. Typically, bonds are issued to finance specific projects. In exchange, the bond issuer guarantees to repay the investment with interest over a certain period of time period.
Suppose your municipality requests a particular financial investment from you. In exchange, your municipality guarantees to return your money plus interest over a certain time period.
For instance, you may purchase a 10-year, $10,000 bond yielding 2% interest. In exchange, your municipality will pay you interest on the $10,000 every six months and return it to you 10 years later.
Types of bonds
The three major types of bonds are corporate, municipal, and government bonds:
Corporate bonds
These are debt instruments issued by a firm to obtain funds for projects such as expansion and R&D. Interest earned on corporate bonds is taxed. To make up for this, the rates on corporate bonds are often higher than those on government or municipal bonds.
Municipal bonds
The bonds issued by a city, municipality, or state to fund public works projects such as schools, roads, and hospitals. Municipal bond interest is tax-free, unlike corporate bond interest. Municipal bonds are classified into two types: general obligation and revenue bonds.
General obligation bonds
Municipalities employ general obligation bonds to fund non-income producing projects such as playgrounds and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality. This means that the issuing municipality can do whatever it takes, like raising taxes, to make sure the bonds are paid back.
Revenue bonds
This sort of bonds, on the other hand, pays back investors with the promised income. For example, if a state sells revenue bonds to construct a new roadway, the income earned by tolls would be used to pay bondholders. Federal taxes do not apply to general obligation or revenue bonds, and local municipal bonds are frequently free from state and local taxes as well. Revenue bonds are an excellent way to invest in a community while earning income.
Government bonds
The bonds such as those issued by the United States Treasury (T-bonds), with a maturity date of one year or less are referred to as “Bills”. Bonds having a maturity date of one to ten years are referred to as “notes,” and bonds with a maturity date of more than ten years are referred to as “bonds.”
The term “treasuries” refers to the full category of bonds issued by a government treasury. Sovereign debt refers to government bonds issued by national governments across the world. Governments may also issue inflation-protected bonds (such as TIPS) and small denomination savings bonds to regular citizens.
How to buy bonds?
Investors can buy individual bonds through a broker or directly from a government agency. One of the main reasons people buy individual bonds is so they can lock in a certain yield for a certain amount of time. The yield on a bond mutual fund or fixed-income exchange traded fund (ETF) changes over time, but this strategy is stable.
It’s important to remember that you have to buy each bond as a whole. Most bonds are sold in $1,000 increments, so you need to have at least $1,000 in your brokerage account to get started. The face value of U.S. Treasury bonds is $1,000, but the minimum bid is $100 and they are sold in $100 increments. You can buy U.S. Treasury bonds through a broker or go straight to Treasury Direct.
The basics of buying a single bond are the same whether you want to buy municipal bonds, corporate bonds, or treasuries: You can buy them as new issues or on a market for used items.
How to make money from bonds?
When you buy bonds, you can make some profit in two ways. The first option is to keep the bonds until they mature and collect the interest payments. Most of the time, interest on bonds is paid twice a year.
The second way to make money with bonds is to sell them for more than you paid for them.
For example, if you buy $10,000 worth of bonds at face value, which means you paid $10,000, and then sell them for $11,000 when their market value goes up, you can keep the $1,000 difference.
There are two main ways that bond prices can go up. If the borrower’s credit risk changes in a way that makes it more likely that they will be able to pay back the bond when it comes due, the price of the bond usually goes up. Also, if the interest rates on new bonds go down, an existing bond with a higher rate will be worth more.
Bond prices and yields, or the interest rate a bond pays, tend to move in opposite directions. If interest rates go up, the price of existing bonds is likely to go down because the coupon they pay is worth less than that of new bonds.
With the US Federal Reserve and the European Central Bank aggressively raising interest rates in 2022, yields have gone up, which means that the prices of government bonds in the US and Eurozone have generally gone down.
Some bonds, like corporate bonds and government bonds, are rated by credit agencies to help figure out how good they are. These ratings help investors figure out how likely it is that they will get their money back. Most of the time, there are two main types of bond ratings: investment grade (higher rated) and high yield (lower rated).
Useful tips for investing in bonds
Whether you are an aspiring investor who wants to try the capital markets yourself, or would like to hire a professional to help you make decisions, always keep these helpful tips in mind:
Know when bonds mature
The maturity date is the day on which you will get the paid back for your investment. Before you commit your money, find out how long your money will be locked up in the bond.
Learn about the bond’s rating
The rating of a bond indicates its creditworthiness. The lower the rating, the greater the likelihood that the bond will default and you will lose your investment. The highest rating (according to the Standard & Poor’s rating system) is AAA. Any bond with a rating of C or below refers as low quality or junk bond, and it has the biggest default risk.
Examine the track record of the bond issuer
Knowing a company’s history might help you decide whether to invest in its bonds.
Determine your risk tolerance
Bonds with a lower credit grade usually have a higher yield to compensate for the increased risk. Consider your risk tolerance and avoid investing purely for the sake of yield.
Consider macroeconomic risks
Bonds lose value as interest rates rise. Interest rate risk is the risk that interest rates will fluctuate before the bond’s maturity date. Avoid attempting to timing the market, as it is difficult to foresee how interest rates will change. Instead, concentrate on your long-term investing goals. Bonds are also vulnerable to rising inflation.
Read the prospectus thoroughly
If you’re considering investing in a bond fund, look into the costs and the sorts of bonds that it includes. The fund’s name may only reveal half of the information; for example, government bond funds may also hold non-government bonds.
Find out about any costs or commissions
Your broker can assist you in deciphering the costs connected with your investment.
Are bonds a good investment?
Once the issuing authority determine the interest rate on a bond and made available to investors, the bond trades in the debt market. The movement of prevailing interest rates then determines how the bond’s price swings.
Bond prices typically move anticyclically. Interest rates climb when the economy warms up, causing bond values to fall. Bond prices rise when interest rates decrease as the economy cools. Bonds may appear to be a fantastic buy during boom times (when prices are lowest) and a sell when the economy begins to recover. But it’s not that easy.
Investors attempt to forecast whether interest rates will rise or fall. However, waiting to buy bonds one might consider as market timing, which is not a smart idea.
Most investors, regardless of age, should dedicate a portion of their portfolio to fixed income products such as bonds. Bonds provide security and predictability to a portfolio.
Investment grade bonds seldom default, despite the chance that a firm would default and suffer a substantial loss. However, this protection comes at the expense of a reduced rate of return.
