Such securities as bonds are often correlated with something sublime and inaccessible to the understanding of mere mortals. In addition, many novice investors do not seriously consider these securities, considering them like instruments of investment and hedge funds with huge capital. In this article we will explain in an accessible form why bonds are a very useful and important tool in any investment portfolio.
Concept of bond
Immediately, we note that bonds are the largest investment instrument in the world in terms of trading volume and provide ample opportunities for investment for both private and institutional investors.
A bond is one of the ways to attract financing, and acts as an alternative to a classic loan, which means that the bond is always based on debt. The issuer (the organization that issued the bond) borrows from investors, promising to repay the debt, as well as interest on the use of funds. That is why the bond has three main properties:
- Urgency. Unlike stocks, bonds have a specific maturity. Depending on the maturity, they emit short-term (from 3 months to 5 years), medium-term (5-10) and long-term (10-30 years) bonds.
- Recurrence. Before buying a bond, the investor expects the issuer to repay the amount of the debt and pay interest.
- Payability. This item applies to interest on the use of funds raised.
It is important that in the case of bonds, the investor can determine in advance the income from the investment, unlike stocks, where there are no guarantees regarding the future value of the asset.
Key parameters of bonds
Nominal cost. This amount is assumed at the time of debt repayment. Unlike stocks, where the nominal value does not play a role, this indicator is very important for bonds, because the investor will receive this amount when paying off the debt.
Coupon rate. The percentage of the nominal value that the investor will receive when paying interest. In general, according to the nature of payments, bonds are divided into discount and coupon.
- Discount bonds the investor buys a bond at a price below par, and the bond is redeemed at par. Other payments are not made on them. Such papers are usually short term and less common.
- Coupon bonds give the holder the right to receive a percentage that is known in advance during the period (most often, it can be payments every 3 or 5 months). But there are also bonds with an unknown coupon (interest), i.e. it may change in time. The type of bond and the conditions for it are specified in the documentation.
The frequency of interest payments. The more often interest will be paid, the more profitable is such an investment;
Bonds, like other securities do not have to be quoted on the stock exchange, so they are divided into exchange and over-the-counter bonds.
Depending on the issuer, bonds are:
State. Most often produced in order to cover the budget deficit. They are considered the most reliable securities on the market.
Municipal. These are bonds that issue, for example, regions or regions to finance any of their projects. Moreover, most often the income on government bonds is not taxed, in contrast to the municipal.
Corporate. Such securities are issued by enterprises. To attract additional funding, companies can simultaneously use both stocks and bonds. However, if in the case of shares, the company will have to share part of its profits and the opportunity to take part in management, then the bonds are considered as an analogue of a bank loan. Income on corporate securities as well as income from shares is taxed.
Also bonds are divided by security. The main risks of the bond are associated with this parameter
- Secured bonds. Rightfully considered the most reliable securities. The fact is that the safety of investments is ensured with the help of collateral (real estate and equipment of the company, other securities). This means that in the event of bankruptcy or liquidation of the company that issued the bonds, the investor will be able to receive a pledge, sell it and return his money. There is another option for security the guarantee of another company or state. If the issuer goes bankrupt, this company will assume liabilities under its bonds;
- Unsecured bonds. In the event of bankruptcy of a company, owners of unsecured bonds will be able to return their funds only upon completion of their bankruptcy procedures and their claims will be satisfied in a general manner along with other creditors of the company. It is possible that in this case the investor will not be able to return all the money invested. However, the average yield on such bonds is higher;
- Subordinated unsecured bonds. This is the most risky type of debt. Again, in the event of a bankruptcy of an enterprise, the owner of such bonds can count on the satisfaction of his claims at the very last, after all the main creditors. It is likely that the company will not have any money after the repayment of funds by the first-order lender. Moreover, even if the issuer has not yet reached bankruptcy, but only before reorganization, its subordinated bonds are immediately written off to zero. But, of course, the yield on such securities is the highest.
The risks of investing in bonds
Despite the fact that bonds are the least risky securities, their purchase involves a number of risks. The main risk factors are:
The risk of default. This risk is present only when purchasing corporate unsecured bonds and is related to the fact that the issuing company goes bankrupt and is unable to fulfill its financial obligations to the investor. In the case of acquisition of government or corporate secured securities such risk is absent.
Risk of restructuring obligations. Risk associated with the likelihood of changes in the conditions of the bonds. For example, changes in the maturity date, the amount of coupon income, the timing and frequency of interest payments. Such decisions can be made at a general meeting of bond holders at the request of the issuer, if he understands that he cannot fulfill his obligations.
Liquidity risk. Possible under the condition when you need to quickly sell existing bonds at a fair price until the redemption. In this case, it is likely that there will be few or no people willing to buy your bonds. It is especially problematic to sell bonds if the issuing company has financial problems or is it just an unknown organization.
Interest risk. It is a little more complicated here the risk is associated with the probability that the average market rates for similar bonds will become higher. If your bonds have a fixed percentage below market, you are the loser your income will be less than it could be. For example, you bought three-year bonds with a yield of 10% per annum. A year later, the average market yield on similar bonds rose from 10 to 12%. It turns out that you will earn less than other investors who will buy securities on new terms. And if you want to sell your bonds ahead of time, you will have to lower the price below par. Only then can your securities interest another investor.
Inflation risk. the risk that inflation will overtake the yield on the bond. It turns out that you do not increase your real capital, but lose a part of it. After all, tomorrow you can buy less on it than today. But in recent years, inflation has fallen dramatically, and the Bank of Russia now intends to keep it at 4%. So this risk is also minimal.
Where and how to purchase bonds
Immediately make a reservation that buying bonds without intermediaries is quite difficult. Only if you do not know exactly which bonds you want to buy and which company. And also provided that they are in free circulation, and not bargained exclusively through the exchange. In all other cases, you will need brokers.
A private investor can buy not only Eurobonds, European and American, but also local government bonds. Most often, brokers in the purchase of debt are large brokerage firms or banks. The choice of broker will directly depend on the bonds that you intend to purchase. To purchase, you need to find a suitable broker, register and replenish your personal account.
Bonds that are denominated in national currency are traded in the same way as ordinary shares. They can be bought or sold through a trading program or by phone call.
Be sure to check with the broker about all commissions that will need to be paid to start trading. Depending on the company, the investor may pay a separate fee for opening a trading account, for the services of a trader, through which the purchase and sale of bonds, depositary services, etc. will take place.
Because of so many different payments, your return on investment may drop significantly, especially when you buy bonds for a small amount.
In order to know if you will get a profit from the investment, we recommend comparing the potential return with the average deposit rate. If after paying all the commissions, the potential return on investment is still higher than from a simple bank deposit, then safely invest. In the opposite case, consider whether it was worth spending so much energy if you do not expect a substantial profit.
Pros and cons of bonds
- The average yield on bonds is often higher than that on a bank deposit, and it can be calculated in advance;
- Financial risk when investing in bonds is significantly lower than when investing in stocks and other securities. So, for example, government bonds are guaranteed by the government, and corporate bonds give the investor the primary right to return the funds in the event of bankruptcy and liquidation of the enterprise;
- The market value of bonds often has a fairly low volatility, so they are easy to sell at a price close to par;
- Income from certain types of bonds is not taxed.
- Investments in bonds do not participate in the deposit insurance system, like other investments in the stock market;
- The yield on bonds is small compared to the more risky instruments of the financial market;
- In some cases, the process of buying bonds may carry some difficulties for the investor, in particular, due to the large number of intermediaries and commissions.
Concluding, we can note that bonds are a financial instrument that helps investors save money and at the same time receive moderate income with relatively low risks. Nevertheless, these risks are borne solely by the investor. If you are trading on a stock through a broker, it is you who make the final decision about buying or selling bonds and are responsible for it.
With proper investment portfolio compilation, bonds can play a key role in hedging risky positions and ensuring, though not large, but stable profits.