Bonds are a suitable instrument for the novice investor. We tell you about the types of bonds, how to assess their yield, what their advantages are and what risks you should be aware of.
What are bonds?
Bonds are actually promissory notes. They are issued by an issuer – a company that needs money, or the government – which can also be an issuer.
People buy bonds and thus lend their money to the company or the government, expecting to receive a certain return. The full amount, timing, and amount of this income payment (if multiple payments are planned) are usually known at the time of purchase. Being able to estimate your benefits in advance is what makes a bond different from other securities.
Bonds are redeemed at maturity, which means the issuer pays the face value to their owners. There are also perpetual bonds – the issuer undertakes to pay income on them regularly, but may never redeem them. In this case, he usually has the right to redeem them at par value at certain dates – for example, once every five or ten years.
In addition to government and corporate bonds, there are investment bonds and structured bonds. They are issued by financial institutions, and the investors’ money is invested not in their own development, but in other stock instruments. These are complex products – buyers have to evaluate the prospects of an entire investment strategy rather than a specific company.
What risks can a bondholder face?
Investing is always a risk. When buying bonds, for example, it is worth considering:
Default risk – the risk that the issuer will go bankrupt and fail to meet its financial obligations to the investor. If you purchased a secured bond, this risk is low. You are likely to be able to get your money back thanks to a pledge, guarantee or surety.
Risk of liability restructuring – the risk that the issuer will change the maturity of the bond, the amount of coupon income, the timing and frequency of payments. The company may offer new terms to investors if it realizes that it is unable to fulfill the original promises.
Liquidity risk is the risk that you will not be able to sell your bonds quickly at a fair price if you want to do so before maturity. There will be few or no buyers willing to buy your securities. This often happens when the issuer has financial problems or is just an unknown company. It’s also usually difficult to find a buyer for structured bonds and structured income bonds.
Interest rate risk is the risk that the average market rates for similar bonds will become higher. If your bonds have a fixed interest rate and it turns out to be lower than the market rate, you lose out – your return could have been higher if you had invested in other securities.
For example, you bought a three-year bond with a yield of 10% per annum. A year later, the average market yield on similar bonds rose from 10% to 12%. So you’ll earn less than other investors who buy on the new terms. And if you want to sell your bonds early, you’ll have to lower the price below par. Only then will your papers be able to interest another investor.
Pros and cons of bonds
The yield on state, municipal and corporate bonds is higher on average than on a bank deposit, and it is usually set in advance. Or there are known rules by which it can be calculated.
- There are risks when buying fixed-income bonds, but they are less than when investing in stocks and other securities.
- The value of high rated bonds does not fluctuate as much as the price of other securities.
- More often than not, they are easy to sell at a price close to par.
- Investments in bonds do not participate in the deposit insurance system like other investments in the stock market. If the issuer goes bankrupt, you can lose everything.
- Yields on safe bonds are small compared to more risky financial market instruments.
- In the case of investment and structured bonds, the risk of not earning a return or even incurring a loss is very high. Even experienced investors find it difficult to assess.
The most reliable bonds, available to all without testing, are a suitable option for the novice investor. They allow you to save money and get a moderate income with relatively low risks.