Investing in bonds is seen as a more conservative approach to investing compared to investing in equities. A bond is a loan you give to an entity such as a company or a government. In return for your investment, the borrower promises to pay you back the full amount on a specific date and pay you interest during that period. Because of this structure, bonds are often referred to as fixed income. You are a lender and you get regular interest rate payment and get your principal back at the maturity. The important relationship you need to know is when the interest rate falls, bond price rises and when the interest rate rises, bond prices falls.
How to Start Investing in Bonds?
Direct purchases through a broker or
Bond Funds and ETFs: Instead of buying individual bonds, you buy a share in a fund holding a diversified portfolio of different bonds. This provides instant diversification and professional management and you do not need a lot of money to start. However, the fund does not have a maturity date so your principal will be subjected to fluctuation in market price. You will also have to pay an annual management fee.
What Are the Key Characteristics of A Bond?
Issuers: Issuers refer to entities borrowing money from you. Common issuers can include governments (e.g. US Treasury bonds) which are generally considered safer, municipalities (state or city governments) that offer tax-free interest and, corporations that can typically offer higher interest but at the same time carry higher risk.
Face Value (Par Value): This refers to the amount the bond will be worth at its maturity date and the amount the issuer promised to pay you back. It’s usually in $1,000 or $5,000 for a single bond.
Coupon rate (interest rate): This is the annual interest rate the issuer is paying based on the bond’s face value. For example, A bond with a $1,000 par value and a 4% coupon rate will pay you $40 in interest per year. While semi-annual payments (twice a year) are very common for bonds, the bond market offers a wide variety of frequencies (quarterly, monthly, etc) to suit different issuers and investor needs.
Maturity Date: This refers to the date when the borrower will pay you back the bond’s full face value. Maturities can range from a few months to years. Short-term can be 3 month, 6 month, 1 to 3 years, medium-term can be 4 to 10 years and long-term 10+ years.
How Do You Make Money From A Bond?
There are two primary ways an investor can profit from bond investment:
Interest Income (Coupon): While you hold a bond, you can collect regular interest payment, which provides a predictable income stream along the way until the bond matures.
Capital Appreciation (Selling a bond at a profit): This is when you do not hold the bond until its maturity, but you buy or sell the bonds on the secondary market much like equities. When you buy a bond and its market price goes up, you can sell it for more than what you paid for, making a profit. The price of a bond market can fluctuate. The most important element influencing a bond’s price is interest rate of an economy.
What is an Inflation-Protected Bond?
Inflation-protected bonds (Treasury Inflation-Protected Securities, TIPS) are government-backed securities to shield savings from inflation. These bonds adjust with inflation to preserve purchasing power and are different from regular bonds with fixed payments. As the principal adjusts with the consumer price index (CPI) and fixed interest rate is then paid on the adjusted principal, your interest payment will rise with inflation. At maturity, you will be paid greater of the original face value or inflation-adjusted principal.
As TIPS are traded based on an inflation-adjusted real yield, the return an investor earns will be above the official US inflation rate if it is held to maturity. The real yield refers to the fixed coupon rate + principal adjustment based on the CPI. It shows you how much purchasing power will grow regardless of future inflation. For example, when a 10-year TIPS is quoted at 1.92%, it is a guaranteed real return. When the real yield rises, TIPS price falls and vice versa similar to nominal bonds’ relationship with the interest rate.
As TIPS offers a real yield and backed by the US government, it is considered to have minimal credit risk. This bond can be a solid diversifier in your portfolio as it protects your savings from unexpected inflation and as a result, they typically offer lower yields than regular bonds.
For example, if inflation is 10%, your principal adjusts to $1,100 from $1,000. If the bond pays 2% fixed rate semi-annually, your interest payment rises to $22 per year ($11 every 6 months) from $20 per year ($10 every 6 months). The income stream will not be constant as inflation cools down or deflation hits, the actual interest payments can decrease if the principal adjusts downward.
Bonds are not risk-free (except for some government bonds which are considered free of default risk). The main risks of bond investing include the followings:
Market risk (Interest rate risk)
If you need to the sell the bond before the maturity and interest rate has risen, you have to sell it for less than what you paid for. When the interest rate rises, bond prices fall, which is a primary risk for the bondholders.
DV01 is a risk measure showing how much money a specific bond or a bond portfolio will gain or lose in value when the yield to maturity changes by one basis point (0.01%). The higher the DV01, the more sensitive a bond is to the changes in interest rate in the market.
Term to maturity, coupon rate, current yield can affect the bond’s duration. The longer the bond’s duration, the higher the risk. Longer-term bonds generally have a higher DV01, more sensitive to interest rate changes than shorter-term bonds. Lower-coupon bonds have a higher DV01 than high-coupon bonds with the same maturity date. Bonds with the lower yield tend to have a higher interest rate sensitivity. Investors want to hedge against this market risk – the risk that higher market interest rates will lower your bond price.
Liquidity risk
This is a risk that you cannot sell the bond quickly without taking a big discount as some bonds are not traded frequently compared to stocks.
Event risk
This is a risk caused by a specific, unexpected event that can change the bond’s characteristics negatively impacting the issuer’s ability to repay its debt. It causes the bond’s price to drop sharply and credit spread to widen. Unlike market risk that can affect all bonds through interest rate changes, event risk is issuer-specific. Most common types of event risk include M&A, leveraged buyout, spin-off, corporate restructuring, litigation, natural disaster, and change in law.
Credit risk (Default risk)
This is the risk that the issuer (especially a company) may run into financial trouble and unable to pay the interest or repay the principal. Credit rating agencies such as Moody’s and S&P grade bonds to help to assess credit risk. Investment grade bonds are safer while high-yield or junk bonds are riskier so they offer higher interest in return. You need to check if the credit worthiness of a company has changed on a regular basis in case you invest in credit bonds.
Inflation Risk
This is the risk that the inflation rate will be higher than the interest rate you are earning from the bond. Over time, this can reduce your purchasing power. For example, if you earn 3% on a bond but inflation rate is 4%, you will be effectively losing 1% in buying power.