Investing in bonds seems pretty easy – the one who purchases the bond lends money to an organization for a certain period and later on the institution pays interest. Although it may seem straightforward, there are actually many variables.
What are the risks of investing in bonds?
You should consider a lot of factors before purchasing a bond: the interest rate, who is the issuer, how is the economy at the moment and so on.
– Is it better to put your money in stocks and not bonds? This would depend heavily on how good of an investor you are. If the investment is riskier, then at least you should be willing to risk it for a bigger return. Time is crucial for bonds – we are talking about a period before it matures, but also its “duration”.
Duration is less than the maturity period in most cases. By looking at it you could measure the sensitivity of the bond in case any interest rate changes occur.
– Insights on bonds
You should never forget about the issuer of the bond too. If investors believe that there is a chance of not getting their money back, they might demand a bigger amount. In most cases the bonds are either corporate and or government. For the latter, the value is directly connected to the expected inflation and interest rates.
BE WARY OF THE INTEREST RATES
The biggest challenges for investors are higher growth and higher inflation. In such situations, banks are expected to increase the interest rates which is not a good thing for bonds. It doesn’t make sense to put your money in bonds and the repayment loses its value.
The corporate kind will also have a “spread” over the government ones. This is done to reflect the riskier nature of the investment.
Another type is the “’junk bond”. This is issued by a very risky firm, but comes with a coupon which is 4% higher than the government bond.
If the economy is in a good state, the spread will be tighter. However, this may lead to issues in the future. It could puch firms to borrow more, purchase less shares, and invest more.
EMERGING MARKET BONDS
When it comes to emerging market bonds things are a bit different. A reflection of the risk is built in the bond. You have to know that you don’t have any assurance about their economic growth. They might perform badly in case of a political crisis, for example.
You will be able to find bonds in particular currencies or such in local ones, which have additional risk attached. Since they are more unsafe, an interest rate is usually paid as a compensation.
You can find out how risky one institution which issues a bond is by looking at the interest paid on a bond (this is the coupon). It also shows the prevailing interest rates. If interest rates and therefore rates on cash savings are high, coupons need to be higher in order to make people invest more.
The latter could also have indexation, which is payments from index-linked bonds that usually rise with the increase in inflation.
As for the yield, it is the return that a certain investor will receive on a bond. In other words, it could be calculated by dividing the coupon by the bond price. At first it is the same as the interest rate and with time passing and the bond maturing it changes value.
CALCULATING THE YIELD
The yield to maturity ratio shows the return for the year in case the bond is held to maturity and there has been a reinvestment in the same yield afterwards with the interest payments.
With the so-called “running yield” there is no consideration of capital loss or gain on redemption. It is similar to a dividend payment.
Another factor to consider are the secondary and primary markets. In reality managers don’t just buy a bond when it is issued and keep it until it matures. They deal with the secondary market.
If you want to become a good investor, it is crucial to get to know the apocryphal predictions regarding the bond market.