Investing in bonds – The ultimate guide
Investing in bonds is a hot topic again in 2023. Bonds are a type of fixed-income investment in which investors lend money to governments, municipalities, or corporations. The bond issuer then pays interest on the money until the bond matures.
Here’s an interesting fact: Bonds are the largest liquid asset class, even larger than the stock market.
Companies issue bonds to raise capital, diversify funding sources, optimize interest rates, and refinance debt. Governments and municipalities in a very similar way issue bonds to fund public projects, support infrastructure investment, promote economic development, refinance debt or cover budget deficits.
Bonds can offer one of the best ratios between return and risk while maintaining a high level of liquidity.
This blog post is the ultimate guide to investing in bonds for individual investors (also called retail or small investors). If you are an individual investor who wants to add bonds to your portfolio and understand how to invest in bonds and perform due diligence on the issuer, you have come to the right place.
The basics – What is a bond and how does it work?
A bond is a type of debt financial instrument in which an investor lends money to an issuer, usually a government or corporation. In return, the investor receives regular interest payments, besides the principal that is paid back at a specified future date, the maturity date.
Bonds are often referred to as fixed-income instruments because they provide a fixed, predictable stream of income to the investor. Unlike stocks, which pay dividends that can vary based on the company’s performance, bondholders receive a fixed amount of interest income based on the terms of the bond.
At maturity, the issuer pays the investor the face value of the bond. In some cases, the issuer may decide to redeem the bond prior to the maturity date, i.e., it pays the investor the face value plus interest due to that date.
When a bond is issued, it can be traded on a secondary market, similar to stocks. The price of the bond fluctuates due to changes in interest rates, the creditworthiness of the issuer, and other factors that affect supply and demand.
The six main reasons to invest in bonds
As mentioned, bonds are, besides stocks, one of the most popular asset classes. In 2020 the global bond market was valued at around $128 trillion, while the global stock market was valued at around $95 trillion.
The main reasons why investors choose to invest in bonds are:
1. Steady income
Bonds are known for their predictable income streams. Unlike stocks, whose value and dividends can fluctuate wildly, bonds typically pay a fixed interest rate for the life of the bond. This makes bonds an attractive option for retirees or other investors seeking regular passive income.
Bonds can provide diversification benefits for an investment portfolio. When you add bonds to your portfolio of stocks, low correlation between the equity and bond market can help reduce overall risk. When stocks are volatile, bonds tend to be more stable, making them an effective diversifier during market fluctuations.
In addition, you can diversify your portfolio among different bonds or bond funds and ETFs. We’ll talk more about the latter soon.
Stocks and bonds are rarely down at the same time:
3. Capital preservation
Bonds are considered a relatively safe investment because they offer a guaranteed return of principal at maturity.
This means that you as an investor can be assured that you will get back your original investment as long as you hold the bond until maturity and mitigate the investment risks in bonds (like the default of the issuer, but more about the risks later).
Bonds can be bought and sold with relative ease, very similar to stocks, providing investors with liquidity and flexibility in managing their portfolio. If you need money at some point for other reasons, you can quickly sell a bond though a broker and get the funds wired to your bank account.
5. Tax advantages
Certain types of bonds, such as municipal bonds, offer tax advantages. Interest income from municipal bonds is generally exempt from federal income taxes and may also be exempt from state and local income taxes, depending on the state in which the bond was issued.
You have to study your local legislation regarding tax advantages of investing in bonds.
6. Protection against inflation
Some bonds, such as Treasury Inflation-Protected Securities (TIPS) on the US market as an example, offer protection against inflation. These bonds are indexed to inflation, meaning that the interest rate is periodically adjusted for inflation. This means that if inflation increases, so does the interest rate at TIPS, providing investors with a hedge against inflation.
If you are not from the US, research if your country offers similar bonds that protect you from inflation.
The 10 technical terms to know when investing in bonds
Bonds are in principle not complex, but there are some technical terms you need to know. Here are the main ones:
The coupon is the interest that the bond issuer pays to the bondholder on a regular basis, usually semi-annually, based on the face value of the bond. It’s called coupon because in the old days a bond was actually a piece of paper where investors would tear part of it (a coupon) and send it to the issuer to get the interest.
The bond yield is the interest income expressed in percentage terms the bondholder receives from the bond. It’s the interest rate that an investor receives on the bond based on the current price of the bond (coupon / current bond price).
Yield to maturity
The yield to maturity is the total return an investor will earn if they hold the bond to maturity. It includes all the interest paid on the bond (income gains) and any potential price change from the point of purchase (capital gains). YTM is the most frequent interest rate shown on bonds.
Face value / Par Value
The face value, also called par value, is the amount the bond is worth at maturity. This is the amount the bondholder will receive from the bond issuer at the end of the bond’s term.
The bond price is the current market value of the bond. It is determined by supply and demand in the bond market and may fluctuate over time. The price is also influenced by factors such as interest rates, inflation, creditworthiness of the issuer, etc.
The maturity date is the date on which the bond expires, and the issuer must return the principal to the investor. Maturity is expressed as the time until that date (for example, bond with 7-year maturity).
The credit rating is an assessment of the bond issuer’s creditworthiness, indicating how likely it is that the issuer will be able to repay the principal and interest on the bond. Bond ratings are assigned by independent credit rating agencies such as Standard & Poor’s, Moody’s and Fitch.
A callable bond is a bond that can be redeemed by the bond issuer prior to maturity. Callable bonds typically offer higher yields than non-callable bonds to compensate for the additional risk to the bondholder.
Zero Coupon Bond
A zero coupon bond is a bond that pays no interest during the life of the bond. Instead, the bond is sold at a discount to its face value, and the bondholder receives the full face value of the bond at maturity.
We’ll dive deep into many of these terms in the following chapters.
How do you make money when investing in a bond?
Now let’s move to the most important topic – how do you make money when investing in bonds? In general, you can make or lose money on bonds in two ways: price changes and interest payments.
When you buy a bond, you pay a certain price for it, which can be different than the face value. If you sell the bond before it matures, its price may have changed. If the price of the bond has gone up, you can sell it at a profit. If the price of the bond has gone down, you will sell it at a loss.
Bond prices are primarily affected by changes in interest rates and inflation. When interest rates rise, the value of existing bonds declines because their fixed coupon payments become less attractive in comparison to the higher yields on new bonds.
Similarly, happens when inflation rises. Then the purchasing power of fixed payments on bonds falls, and the prices of existing bonds may fall to compensate.
The creditworthiness of the issuer or the company that issued the bond can also affect the price. If the issuer’s credit rating improves or deteriorates, this can affect investor confidence in the bond and its price.
The maturity of a bond has an influence on the magnitude of the price changes. Bonds with longer maturity are usually more sensitive to changes in interest rates than bonds with shorter maturity. That’s because they carry a greater risk that inflation and other economic factors will affect the value of the bond over time.
The second way you earn money by investing in bonds is with interest payments. Bonds pay interest to bondholders at regular intervals, usually annually or semiannually.
If you hold a bond to maturity, you receive the face value of the bond plus any interest payments due to you. If you sell the bond before maturity, you receive the market value of the bond, which may be more or less than the par value. The amount of interest paid depends on the size of the coupon, which is set when the bond is issued.
Holding versus trading the bond
Holding a bond means that you hold the bond to maturity and receive interest payments during the term of the bond. When a bond is held to maturity, you receive the face value of the bond at maturity.
Holding a bond is generally considered a more conservative investment strategy because it provides a predictable income stream.
Bond trading, on the other hand, means that you buy and sell bonds in the secondary market to make a profit from the bond’s price fluctuations. Bond trading can be more speculative than holding a bond to maturity because the investor is trying to time the market and profit from changes in prices.
Trading bonds can be more volatile and carries more risk than holding a bond to maturity. In the end, you have to decide which strategy works better for you – holding or trading.
Here is a practical example:
Let us take a look at the German government bond issued in early 2023. The bond was issued with a coupon of 2.5%. This means that the buyer will receive 2.5% every year until the maturity date in 2025. But what if you want or need to sell the bond earlier?
Well, you can sell it on the secondary market (stock exchange) – you see the two buttons Buy and Sell. The initial value of the bond is 100. The price of this bond has dropped to 98.90 as you can see below (on 2/27). This means that if you buy the bond today at this price, your return will be 3.0620% per year (but mind the holding period), as you will receive the full principal at maturity.
The seller of the bond, on the other hand, would have a lower return because he paid full price and will only receive 98.90 % of the bond’s value. However, he will receive all the accrued interest until the next interest payment date.
That also leads us to the difference between investing in a bond for the long-term and trading a bond.
The yield curve explained
The last important concept you need to understand is the yield curve. The yield curve is a graphical representation of the interest rates of bonds with different maturities.
In a normal yield curve, bonds with longer maturities have higher yields than bonds with shorter maturities. This reflects investors’ expectations that the economy will grow over time and that inflation will rise. This is referred to as a positive yield curve.
- Normal yield curve: Bonds with longer maturities have higher yields than bonds with shorter maturities.
- Inverted yield curve: Bonds with longer maturities have lower yields than bonds with shorter maturities.
However, in some situations, the yield curve can reverse, meaning that bonds with shorter maturities have higher yields than bonds with longer maturities.
This is often seen as a signal of an economic slowdown or recession. An inverted yield curve occurs when investors are more concerned about the short-term outlook than the long-term outlook. This can lead them to sell longer-maturity bonds and buy shorter-maturity bonds, driving up the yield on shorter-maturity bonds and pushing down the yield on longer-maturity bonds.
The most popular types of bonds
We know many different types of bonds. The following are some of the most common types:
1. Government bonds
These bonds are issued by a government and are considered the safest bonds available, if the country has a good credit rating.
They are backed by the full faith and credit of the government that issues the bond, which means there is a very low risk of default. Government bonds come in a variety of maturities, from short-term bills to long-term bonds.
2. Corporate Bonds
These bonds are issued by companies to raise capital for various purposes, such as financing expansion or repaying existing debt.
Corporate bonds are rated by credit agencies based on the creditworthiness of the issuer, with higher-rated bonds offering lower yields but lower risk.
3. Municipal bonds
These bonds are issued by state and local governments to finance public projects such as roads, schools, and hospitals. Municipal bonds in the US additionally offer tax advantages because the interest earned is usually exempt from federal income tax and may also be exempt from state and local income tax.
4. Agency Bonds
These bonds are issued by government-sponsored entities such as Fannie Mae and Freddie Mac to fund specific programs such as housing initiatives. Agency bonds are generally considered less risky than corporate bonds but may offer slightly higher yields than government bonds.
5. Zero coupon bonds
These bonds do not pay periodic interest like conventional bonds. Instead, they are sold at a discount to their face value and the full face value is paid at maturity. The yield on a zero-coupon bond is the difference between the discounted purchase price and the face value at maturity.
6. Inflation-linked bonds
These bonds, also known as TIPS, are issued by the U.S. government and are designed to protect against inflation. The interest rate of TIPS is adjusted based on changes in the Consumer Price Index, which means that the yield on the bond and its face value keeps pace with inflation.
7. Junk Bonds
Junk bonds, also known as high-yield bonds, are bonds issued by companies or corporations with a lower credit rating than investment-grade bonds.
These bonds have a higher risk of default than investment-grade bonds, meaning it is more likely that the issuer will not be able to make the interest or principal payments on the bond.
These are just a few of the most common types of bonds. There are other specialized bonds, such as convertible bonds, callable bonds, and high-yield or junk bonds, that have unique characteristics and risks.
In addition, there are many other different bonds, some even with funny names. Here is an interesting list:
Green bonds, foreign bonds, sovereign bonds, agency bonds, hybrid bonds, senior secured bonds, senior unsecured bonds, subordinated bonds, catastrophe bonds, revenue bonds, taxable municipal bonds, tax-exempt municipal bonds, collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs) synthetic bonds, private activity bonds, samurai bonds, bulldog bonds, Yankee bonds, kangaroo bonds, etc.
You can explore some of these terms if you find them interesting.
What are realistic returns from bond investments?
Historical bond yields vary depending on the type of bond and the time period under consideration. In general, bonds have had lower returns than stocks, but they have also been less volatile and less risky.
Here are some average return statistics for various types of bonds in the US:
- US Treasury Bonds: According to historical data from the US Treasury Department, the average annual return for 10-year Treasury notes from 1928 to 2020 was 5.2 %, and for 30-year Treasury bonds it was 5.5 %.
- Corporate Bonds: According to Bloomberg Barclays Indices, the average annual return for investment-grade corporate bonds from 1998 to 2020 was 5.4 %, and for high-yield corporate bonds it was 7.2 %.
- Municipal Bonds: According to Bloomberg Barclays Indices, the average annual return for municipal bonds from 1998 to 2020 was 4.0 %.
- International Bonds: According to the MSCI World Sovereign Bond Index, the average annual return for developed market government bonds from 2000 to 2020 was 4.2 %.
Historical bond returns:
One of the best performing bonds in recent history was the 100-year Austrian government bond issued in 2017. The bond offered a coupon of 2.1%, and investors were willing to pay a premium for the long maturity. The bond’s price rose significantly in the months following its issuance, and investors who bought the bond at the time saw substantial profits.
One of the worst performing bonds in history was the 2001 Argentine government bond. The bond defaulted in 2002, resulting in significant losses for investors who held the bond. The default was a result of the severe economic crisis in Argentina, and the country’s debt was restructured in the following years.
We should also mention that 2022 was the worst-ever year for U.S. bonds. On the other hand, bonds are probably coming back strong in 2023.
Here are US corporate bond returns in the past four years (Returns on iShares USD Corporate Bonds UCITS ETF Acc):
The main risks you have to be aware of when investing in bonds
While investing in bonds can offer a number of benefits, there are also some risks that investors should be aware of. Some of the major risks associated with investing in bonds are:
1. Interest Rate Risk
Bond prices are sensitive to changes in the interest rates set by the central bank. When interest rates rise, bond prices usually fall, and when interest rates fall, bond prices usually rise.
This means that investors who hold bonds may suffer losses if interest rates rise unexpectedly, especially if they want to sell the bond before it matures.
2. Credit Risk
Bonds are issued by corporations, municipalities, and governments, and the creditworthiness of these issuers may vary.
Investors holding bonds from lower-rated issuers may face default risk (the organization going bankrupt) if the issuer is unable to make interest or principal payments.
3. Inflation risk
Bonds are subject to inflation risk, as we also talked about, which is the risk that rising inflation will erode the purchasing power of interest and principal payments.
4. Call risk
Some bonds may be called or redeemed by the issuer before reaching maturity. This may result in investors receiving their principal back sooner than expected, which may affect their return. Usually, the call option also comes with a penalty in favor of investors.
5. Liquidity Risk
Although bonds are generally considered liquid investments, some bonds may be more difficult to sell than others. This can make it difficult for investors to exit a position quickly when needed. But the most popular bonds have rarely a liquidity issue.
6. Currency Risk
When investors buy bonds denominated in a foreign currency, they are exposed to currency risk, which is the risk that fluctuations in exchange rates will affect the value of their investment. When you buy a bond in a foreign currency, you also need to be aware of (or even hedge your investment against) currency risk.
By understanding the risks associated with bonds, you can make more informed investment decisions that are consistent with your investment objectives and risk tolerance. In the next chapter we’ll dive deep into bond ratings, since they are one of the best ways to mitigate the risks.
Understanding the bond ratings
Bonds are rated by independent credit rating agencies such as Standard & Poor’s, Moody’s, and Fitch. These agencies evaluate the creditworthiness of the issuer and assign a rating to the bond based on the issuer’s ability to meet its financial obligations.
The rating assigned to a bond reflects the rating agency’s opinion of the issuer’s creditworthiness and the likelihood that the issuer will default on the bond. Bond ratings typically range from AAA (the highest rating) to D (the lowest rating).
Here is a brief explanation of each credit rating level:
- AAA (or Aaa): Bonds with this rating are considered to have the highest credit quality and the lowest risk of default. The issuer is able to meet its financial obligations to a high degree.
- AA (or Aa): Bonds with this rating have very good credit quality and very low default risk. The issuer is very well able to meet its financial obligations.
- A: Bonds with this rating have a high credit quality and a low risk of default. The issuer is in a good position to meet its financial obligations.
- BBB (or Baa): Bonds with this rating have adequate credit quality and moderate default risk. The issuer is able to meet its financial obligations satisfactorily.
- BB (or Ba), B, and CCC (or Caa): Bonds with these ratings have speculative credit quality and high default risk. The issuers have a high ability to meet their financial obligations, but adverse economic conditions or changing circumstances could affect their ability to do so.
- CC (or Ca) and C: Bonds with these ratings are considered highly speculative and have an extremely high risk of default. The issuers have very limited ability to meet their financial obligations.
- D (or C): Bonds with this rating are in default or expected to be in default soon. The issuer has defaulted on its financial obligations.
Rating agencies evaluate a number of factors when assigning a rating to a bond, including the issuer’s financial health, debt levels, profitability, cash flow and industry trends.
They also consider any outstanding debt, the structure of the bond, and the terms of the bond, such as the interest rate, maturity, and any collateral backing the bond.
Bond prospectus – The doc with all the relevant information
A bond prospectus is a legal document that provides potential investors with detailed information about a particular bond offering. It is usually prepared by the issuer of the bond (or its investment banker), such as a company or government agency, and is required by securities regulations.
The bond prospectus contains all the important information about the terms of the bond, such as the maturity date, interest rate, and principal amount. It may also contain information about any collateral pledged to secure the bond and any covenants or conditions provided by the issuer that may affect the value of the bond.
In addition to information about the bond itself, the prospectus also contains information about the issuer of the bond, such as its financial statements, credit rating, and other relevant information that may affect the issuer’s ability to repay the bond.
It’s not that easy to find bond prospectus. You can find them on websites of regulators, stock exchanges, issuer’s investment centers or different paid services for investors.
An example of the EU regulated prospectus:
An example of prospectus from a US company:
The most practical ways to buy a bond
Buying a bond is fairly easy. There are several ways to buy bonds, the following three being the most practical with minimum transaction fees:
Online brokerage firms
Many online brokers offer access to a wide range of bonds from various issuers. Online brokers can be a convenient option for investors who prefer to manage their investments online.
Here is an example of Interactive Brokers platform:
Bond mutual funds or ETFs
Bond mutual funds and exchange-traded funds (ETFs) offer investors a diversified portfolio of bonds. These funds are managed by professional investors and can be a convenient way to invest in bonds.
Here are a few examples of a very popular ETFs:
- Vanguard Total Bond Market ETF
- iShares Core U.S. Aggregate Bond ETF
- Vanguard Total International Bond ETF
- Vanguard Short-Term Corporate Bond ETF
- Vanguard Intermediate-Term Corporate Bond ETF
You can research the bond ETFs on sites like justETF.com and similar.
Directly from the issuer
Some bonds are sold directly from the issuer, such as municipal bonds. However, this option may be less convenient than buying bonds through a broker, and the selection of bonds may be smaller.
For the U.S. investors it’s also worth mentioning TreasuryDirect. It’s a website operated by the U.S. Treasury Department where investors can buy government bonds, notes, and bills directly from the government.
Please also note that there are usually a number of fees associated with the purchase of a bond, depending on how the bond is purchased and the terms on which it is offered.
These fees may include brokerage fees, markups and markdowns, underwriting fees, custodial fees, redemption fees and others. It is important that you carefully review the terms of a bond offering and understand the fees and costs associated with the transaction.
How much of your portfolio should you allocate to bonds?
We’ve come to the final question – How much of your funds should you invest into bonds? The percentage you should invest in bonds in your investment portfolio depends on a variety of factors, including your investment objectives, time horizon, risk tolerance and current market conditions.
However, there are a few formulas or general rules of thumb that you can use as a starting point for determining how much to invest in bonds. Maybe one of these works just fine for your investment strategy:
One of the most common formulas involves subtracting your age from 100. The resulting percentage is the amount you should invest in stocks, with the rest in bonds. For example, if you are 40 years old, you should invest 60 % in stocks and 40 % in bonds.
Similar to the age-based allocation, this formula suggests subtracting your age from 120 instead of 100. For example, if you are 40 years old, you should invest 80% in stocks and 20% in bonds.
This formula suggests investing 70% in bonds and 30% in stocks, regardless of age.
This formula suggests investing 80% in stocks and 20% in bonds, regardless of age.
It’s important to note that these formulas are only suggestions, and the best allocation for you as an investor’s depends on your specific financial goals, risk tolerance and other factors. The older you are the more bonds should probably be in your portfolio.
Last but not least – Should you invest in bonds?
In summary, bonds are definitely a valuable addition to any investment portfolio, especially for conservative investors or when you become older. Bonds offer a predictable income stream, diversification, capital preservation, inflation protection and tax benefits.
While bonds may not offer the same potential for high returns as stocks, they do provide a level of security and stability that can help investors achieve their long-term financial goals.
So, in conclusion, bonds should definitely be part of your portfolio in 2023.