Understanding Bonds Investment

Starting your journey into investments and the world of finance can be both exciting and a bit confusing. Maybe you’ve heard about bonds, but what are they, really? Why do people buy them, and what makes them different from other things you can invest in?

This is where my personal learning journey begins, and I invite you to join me. This article is here to help you (and me) understand bonds in simple terms, reflecting both my own discoveries and key concepts that are vital to grasp.

We’ll talk about what bonds are, how they work, and why they might be something you want to consider for your own investing adventure. Ready? Let’s get started!

Understanding Bonds

A bond represents a loan made by an investor to a borrower. Usually, bonds are issued by governments and companies to get funds for their own projects and investments.

The Coupon Rate and the Coupon Dates

To make the loan interest to the investor, the issuer agrees to pay the bondholder regular interest, often every six months. This interest is called the coupon rate. And the dates on which the bond issuer will make interest payments are known as Coupon Dates.

The Maturity Date

A bond also has a set period known as the maturity date. When this date arrives, the issuer must pay back the original amount borrowed (the principal) to the bondholder.

You Can Buy or Sell Bonds in the Market

Bonds can also be bought and sold in the market. If you own a bond and want to sell it before maturity, its value may be higher or lower than what you paid, depending on interest rates and the issuer’s perceived risk.

The Face Value is Always Constant

This leads us back to the face value (par value). This refers to the amount of money the issuer has agreed to pay back to the bondholder upon maturity. It’s the original worth of the bond and is used to calculate the coupon or interest payments throughout the bond's life.

You can trade a bond in the market for more or less than its original price. However, at the maturity date, you will only be paid the original price (the face value).

You may be wondering why you would buy a bond that is higher than its face value or even sell a bond for less than the price you paid for it. But before we do it, let’s recap what interest rates are.

Understanding Interest Rates
Interest rates are a fundamental aspect of the financial landscape, representing the cost of borrowing money or the reward for saving it.

Set by central banks and influenced by various economic factors, interest rates serve as a tool to control money supply, inflation, and economic growth.

When the economy is sluggish, central banks might lower interest rates to encourage borrowing and spending, thereby stimulating growth.

Conversely, when the economy is overheating, higher interest rates can be used to curb borrowing, spending, and potential inflation.

Buying Bonds at Higher Prices

Imagine you purchased a bond several years ago with a face value of €1,000 and a coupon rate of 5%. At that time, this 5% rate was in line with market interest rates. The bond pays you €50 annually in interest (5% of €1,000).

Now, let’s say market interest rates have since fallen to 3%. New bonds being issued are only paying 3% interest, or €30 annually on a €1,000 face value. Your existing bond, with its 5% coupon rate, is now more attractive, as it pays €50 annually compared to the €30 from newly issued bonds.

Investors looking for higher income might be willing to buy your bond at a premium (more than the face value) because of the higher interest income it offers.

Selling Bonds at Lower Prices

Consider another scenario where you own a bond with a face value of €1,000 and a coupon rate of 3%. Suddenly, market interest rates rise to 5%. New bonds are now being issued with a 5% interest rate, paying €50 annually on a €1,000 face value.

Your existing 3% bond, paying only €30 annually, becomes less attractive compared to the new bonds offering €50. If you wish to sell your bond, you might have to do so at a discount (less than face value), as investors would prefer the new bonds that pay higher interest.

The Inverse Relationship: Interest Rates and Bond Prices

This means that bond prices are inversely correlated with interest rates: when rates go up, bond prices fall, and vice-versa.

When interest rates rise, newly issued bonds offer higher coupon rates, making existing bonds with lower fixed coupon rates less attractive. Consequently, the market price of existing bonds falls.

Conversely, when interest rates decline, existing bonds with fixed higher coupon rates become more appealing, leading to an increase in their market price.

Understanding the Options

In the world of bonds, investors have different options to choose from:

Fixed Coupon Rates

Bonds with fixed coupon rates offer a constant interest payment over the life of the bond. The coupon rate is set at the time of issuance and doesn’t change, regardless of fluctuations in market interest rates.

For example, a €1,000 bond with a fixed coupon rate of 5% will pay €50 annually until it matures.

Investors who seek predictable income and want to lock in current interest rates may find these bonds appealing.

Variable Coupon Rates

Unlike fixed coupon bonds, variable or floating-rate bonds have interest payments that adjust in response to changes in market interest rates. The coupon rate is often tied to a reference rate, such as LIBOR or EURIBOR, plus a fixed spread.

For instance, if the reference rate is 2% and the spread is 1%, the bond’s coupon rate would be 3%. If the reference rate rises to 3%, the coupon rate will adjust to 4%.

This structure allows the bond’s interest payments to keep pace with changes in the economic environment.

Zero-Coupon Bonds

Zero coupon bonds do not make periodic interest payments. Instead, they are issued at a discount to their face value and mature at that face value.

The difference between the issue price and the face value represents the interest income. These bonds may be suitable for investors who want a guaranteed return at a specific future date and do not require periodic interest income.

Puttable Bonds

Puttable bonds give the bondholder the right to “put” or sell the bond back to the issuer at a predetermined price and date(s) before maturity.

This option provides the bondholder with greater protection against rising interest rates, as they can sell the bond back if the market value falls. It can be an attractive option for more risk-averse investors, providing a safety net in an uncertain interest rate environment.

Callable Bonds

Callable bonds allow the issuer to “call” or redeem the bond before its maturity date at a predetermined price.

This typically happens when interest rates fall, allowing the issuer to refinance at a lower rate. While callable bonds often pay a slightly higher interest rate to compensate for this risk, they may not be suitable for investors who need certainty in the bond’s duration, as they may be called away in a declining interest rate environment.

Convertible Bonds

Convertible bonds can be converted into a predetermined number of common shares of the issuing company, often at the investor’s discretion.

These bonds combine the features of bonds and stocks, providing potential upside if the company’s stock performs well while still offering the relative stability and interest income of bonds. They may be attractive to investors looking for a mix of growth potential and income.

Buying Bonds

There are different ways of buying bonds. You can buy them directly from the government, through a bank, through a broker platform, or through a fund or ETF.

Personally for me, I prefer to buy them through ETFs. And fortunately, Degiro, the broker that I use in Europe, offers a selection of both government and corporate bonds. For example:

• Invesco US Treas Bd 7–10 Year UCITS ETF Dist
• iShares $ Treasury Bd 20+yr UCITS ETF USD Dist
• iShares $ Treasury Bond 0–1y UCITS ETF USD Dist
• SPDR Bloomberg Barc 1–3 M T-Bill UCITS ETFUSDAcc
• UBS LFS Bloomberg BarclaysTIPS 1–10UCI ETF(EURh)Aa

If you are located in Europe and want to start investing in bonds today. You can easily create an account on Degiro, one of the most popular brokerage companies in the continent, and start buying ETFs like the ones I mentioned previously.

Conclusion

So there we have it! You’ve just taken a big step in understanding bonds and what they can do for you. From knowing how interest affects bonds to exploring the different types you can invest in, you now have the basics to decide if bonds are something you want to add to your investment toolkit.

But we’re not done yet! Next, we’ll be diving into how to analyze bonds, a crucial step in making informed investment decisions. It might seem tricky at first, but just like any journey, the more you learn and explore, the more comfortable you’ll become.

Happy investing!

Disclaimer

This article is intended for informational and educational purposes only and should not be considered financial or investment advice. Investment decisions should be based on individual circumstances, goals, and risk tolerance. If you have specific financial questions or need personalized guidance, it is recommended to consult with a qualified financial professional or investment advisor who understands your individual situation.

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