How to Invest in Bonds
How to Invest in Bonds
If you have ever watched a Hollywood film on financial investment such as Wall Street, Trading Places, or The Big Short, you may have heard the term “bonds” used. Bonds have been around for centuries and are a way for companies or governments to grow money for investing in various projects. Bonds have been issued by organizations and governments for all manner of programs.
One project that saw bonds issued was in the United States during World War II. The government was able to sell bonds to the public and pay for the war effort. After the war, the government had an obligation to pay back investors for those bonds. Thus, the investment was paid off with interest. Let us look more into how bonds work and how you can make money from investing in them.
How do bonds work?
Bonds are simply a way for a government organization to raise funds. A municipality may need to raise money for a project and you can invest your money to help complete it. When investing in a bond issued by a local government, you will be paid back for the investment made along with interest. The payments will be made over a defined period of time.
You may purchase a $10,000 bond for 10 years at 3% interest from your local city government. In exchange for the money used to buy the bond, the city promises to pay you interest every six months. At the end of the 10-year period, your $10,000 will be repaid on top of the interest you made twice yearly.
Can you make money from investing in bonds?
You can make money in two different ways by investing in bonds. First, you can purchase and hold onto the bond until their maturity date while collecting all of the interest payments made on them. The interest on bonds is typically paid twice a year.
The other way to make a profit off of bond investments is to sell them a higher price than what you originally paid for them. If you paid $10,000 for a bond, you may sell the bond for $11,000 when its market value rises. By selling the bond when the market value increases, you pocket a profit of $1,000.
There are two reasons bond prices can increase over time. A borrower’s credit risk profile can be upgraded, which means it is more likely to repay the bond once it reaches maturity. If this occurs, the price of the bond usually rises. In addition, if interest rates on recently issued bonds decrease, the value of the existing bond at a higher rate increases.
What are the types of bonds?
You may be most familiar with the term ‘government bonds’. There are two types of bonds issued by local or national governments. There is also one issued by private companies.
Each type of bond offers its own reward and risk.
- Corporate bonds – A Corporate Bond often provides higher interest rates than other types of bonds. However, the companies that sell a Corporate Bond are more likely to default than government entities. Therefore, you do not get your money back.
- Municipal bonds – A Muni Bond is issued by a state, city, or another local government entity to raise money for public projects or to provide public services. A city may issue municipal bonds to raise funds to build a new bridge or renovate an existing neighborhood park.
- Treasury bonds – Also known as a T-bond, these are issued by the United States government. T-Bonds have a lack of default risk; therefore, the government does not have to offer them at the same interest rates as corporate bonds. Interest rates are often lower.
How to buy and invest in bonds?
Bonds are traded “over the counter”, which makes them different than stocks that are bought and sold publicly. You will need to hire a broker to invest in bonds. However, the good news is that treasury bonds can be bought directly from the US government. Therefore, you can cut out the middleman and all the profits go to you.
One of the drawbacks of bonds is that investors may not be sure they are getting a “fair price” for their investment. Stocks are sold in a centralized place – Wall Street – and it is easy to see whether or not the price is correct. Bonds are dealt with differently and you don’t always know if the price is accurate. The Financial Industry Regulatory Authority (FINRA) oversees the regulation of the bond market to some degree. It posts transaction prices when the data becomes available.
What are the benefits of investing in bonds?
You will find several benefits when investing in bond. Benefits include:
- Security – They are relatively safe in terms of investments. Bond values often stay steady and do not fluctuate as much as stock prices.
- Income – They offer a predictable and steady income stream. You will receive a fixed price twice yearly for the term of the bond.
- Community – You may help improve your local area when buying a bond. Not only will you make money, but the feel-good factor will increase.
- Diversification – Investing in bonds allows you to diversify your portfolio. Stocks typically outperform bonds over time. However, having both stocks and bonds in your portfolio is a safe way to go about investing money.
Should I invest in bonds?
While bonds sound great, you will need to sit down and consider if investing in them is right for your portfolio. Bonds are often times safer than stocks. If you want to play it safe and avoid losing money, purchasing bonds is a great way to go.
If you have already invested a significant amount of money into stocks, then diversifying your portfolio with bonds can protect yourself from the markets fluctuating. As investors age, they should focus on buying more bonds and selling off more of their stocks. Why? Bonds are safer and provide security to investors as they grow older.
So, should you invest in bonds? There are some great upsides to buying bonds, but in the end, you will need to ensure investing in them is right for you.
Zanthe Alexander Bentley is a finance veteran with over 25 years’ wealth management experience advising both family offices and institutions on their corporate finance requirements including capital raises (debt & equity), restructurings and M&A activities. He has significant experience in investment management and investment banking and spent nine years at UBS focused on convertible bond arbitrage and equity derivatives.
Prior to getting involved in Asset Management he expanded a small Spanish brokerage from a handful of staff in Barcelona to a diversified brokerage company with over 150 personnel spread across 9 countries, transacting deals from High Grade to High Yield Fixed Income and Loans; Structured Products through to exchanged traded equities.
After taking time to focus on family office activities in Asia, Zanthe-Alexander now leads an ambitious zero-leveraged fund providing exceptional growth and income to Sophisticated Investors.
Zanthe Alexander Bentley Twitter: https://twitter.com/BentleyZanthe
How to Invest in Bonds