What are bonds

Bonds are considered conservative investment assets that allow you to preserve invested capital while earning a fixed return. We tell you about the peculiarities of bonds today, how you can make money on them, and what risks you should be aware of.

Bonds are debt securities which are issued by the government or companies to raise money for business development. In simple words, the buyer of such an asset becomes the creditor of the issuer. The bond price is fixed. This is the amount of principal that the investor receives when the security matures.

The date of the first sale of a security is called the issue date, and the date of repayment of the par value of bonds is called the maturity date. Between these two dates, the issuer regularly pays interest, called coupons.

The word “coupon” was previously used in its literal meaning. The name originated because before the advent of electronic trading, investors were given paper certificates with coupons to pay interest on when bonds were purchased. When the payment date came, the holder simply cut out the coupon and mailed it to the issuer for a check.

Today, coupons are paid into an investor’s bank or brokerage account. The frequency of payments and the amount of the coupon income are usually known when you buy at the market price of bonds. Interest is usually paid every three or six months.

Unlike shareholders, bondholders do not participate in the issuer’s profits. The terms of return of the invested money are known in advance and do not depend on the company’s financial results. In very rare cases, such as bankruptcy or default, bond payments can be changed or canceled.

Investors can buy securities on or off the stock exchange. Bonds of trusted companies and government bonds are traded on the stock market – they are easiest to buy through a broker online. All you have to do is to open a brokerage account, deposit it and make a transaction. 

How to invest in bonds – Types of bonds

How to invest in bonds? According to the type of issuer, bonds are divided into three groups: corporate, government and agency bonds.

Corporate bonds

These are raising capital by companies without issuing stock or seeking other forms of financing. Corporate bonds usually offer higher yields than government bonds. This is because even profitable companies have a higher risk of default than the government, so investors expect to be compensated for the risk in the form of higher potential returns. 

Government bonds

Government bonds are issued to finance government expenditures. They are considered the most reliable asset among debt securities and for this reason are inferior to corporate bonds regarding yield. 

Agency bonds

How to invest in bonds for beginners? Many government-related agencies such as federal land development agencies, insurance funds and pension funds also issue debt securities. Some are backed by the profits of the individual institution, while others are guaranteed by the government sponsor.

Mutual funds may also be issuers of such bonds. Yields on agency bonds are higher than those on federal bonds, and the interest on them is not taxable.

In addition to classification by type of issuer, there are also other types of debt securities with different. For example, according to the rate of coupon yield, they are divided into:

• Into bonds at a constant rate that does not change throughout their life. Such securities are resistant to any changes and fluctuations in the market;
• Fixed-rate bonds: for each period there is a certain coupon rate that is known in advance;
• Bonds with a variable coupon: the interest rate is fixed for a certain period, after which the issuer has the right to change the rate;
• Floating-rate bonds: the interest on the coupon is linked to macroeconomic indicators.

How to invest in bonds? Bonds are classified according to their maturity:

• Short-term – maturing in less than a year.
• Medium-term – one to five years.
• Long-term – more than five years.
• Perpetual – without a maturity date.

How to invest in government bonds? Government bonds can also be classified according to the purpose of issuance, for example:

• military – issued by the government to raise money to cover military expenses;
• The government issues climate bonds to raise money to prevent and respond to adverse climate conditions and natural disasters.

What is the advantage of a bond over a deposit in a bank?

The advantages of bonds compared to bank deposits are as follows:

• Higher yields. This is the main advantage of bonds compared to deposits. Average yields on government, municipal and corporate debt securities are higher than bank deposit rates.
• Reliability. This is advantageous only for liabilities secured by state or municipal authorities.
• Ability to use bonds as a means of securing a loan. 

How to choose bonds

Criteria for choosing an asset depend on the needs and expectations of a specific investor. Investing in bonds should be based on such parameters as:

• Reliability. Here it’s simple: the more reliable an asset is, the lower its yield. Factor of reliability in bonds is especially important when choosing long-term investment instruments. 
• Coupon rate. The inflation rate should serve as a guideline here. If coupon payments in the sum for a year overlap inflationary expectations, then such a tool can be considered for investment; if not – you should choose a variant with a higher yield;
• Maturity. Long-term bonds (over 10 years) are more suitable for forming an individual pension plan. 
• Issue and circulation rules. Before buying, it is important to clarify the frequency of coupon payments, as well as to learn whether the issuer has the right to early redemption or repurchase liabilities.