An overview of the bond market and how to invest

The bond market is incredibly large and one that plays an irreplaceable role for governments, municipalities and companies. In the United States alone, the bond market is worth more than $40 trillion. The treasury has bonds worth more than $13 billion. It is followed by corporate bonds and mortgage related securities which have bonds worth more than $9 billion respectively. This is much more than the stock markets that are worth more than $30 trillion. Globally, the size of the bond market has risen $100 trillion. This article will explain what bonds are, how they work and the various ways you can invest in them.

What is a bond?

A country generates its income through taxes. After collecting taxes, the government uses the money to pay its employees and to fund development. To build infrastructure, the government has three choices. First, it can print money. This is an unreliable method because it would lead to increased inflation. Second, it can approach the country’s banks and borrow money. This is an unattractive method because banks will charge it a higher interest rate. Some banks could not afford to fund large government projects. Third, the country can go to the financial market and borrow money. Here, the government will tell the market the amount it needs, the coupon rate and the period it intends to take to pay back the money. Depending on the country’s bond rating, investors will provide it with the funds. This type of bond is known as a treasury bond.

Similarly, when a company wants to accelerate its growth, it needs money. Like a government, it can go to a bank and borrow the funds. As with the government, this is an unreliable method because banks tend to charge high interest rates. The company can also sell equity. Here, it sells shares to the market. If the company is private and does not want to give equity or if it is a public company that does not want to dilute its ownership, the best option is to go to the market and issue a bond. This is a reliable method because it has flexible terms and lower interest rates than commercial paper. This type is known as a corporate bond.

The other types of bonds are municipal bonds and supranational bodies like the World Bank. Municipal bonds are also known as muni bonds.

Key Terminologies

To invest in the bond market, it is important to understand a number of terminologies. These are:

Issuer: This is the entity that is issuing the bond. A company or entity that goes to the market to ask money in the bond market is the issuer.
Credit Rating: To invest in the bond market, investors need to know how secure the issuer is. Since they don’t have time or expertise to research the issuer, they use the services of a rating agency who provide the rating. Bonds of a country like Germany are highly rated while that of a volatile country like Venezuela have a low rating. Credit ratings range from AAA (Triple A) to C or D (junk).
Rating Agency: This is a company whose work is to provide the credit ratings. The ratings industry is an oligopoly controlled by S&P Global, Fitch, and Moody’s.
Term to Maturity: This is the period in which the issuer will take to pay back the debt. The term of maturity ranges from 1+ years to 30 years. Longer-dated bonds are usually more expensive than shorter-term bonds.
Principal: This is the amount of money that the issuer raises in the market. If you buy a bond and hold it to maturity, you will receive your principal back.
Coupon Rate: This is the interest rate in which the issuer pays back to the lenders. The coupon is paid annually or biannually. A bond that pays regular annual or semiannual rates is known as plain vanilla.
Nominal rate: This is the interest rate that the issuer agrees to pay during the term of the bond.
Yield: This is the amount of money you generate from a bond. It is usually quoted in percentages. The two types of yields are nominal yields and current yield. A nominal yield is the profit you will generate if you hold the bond to maturity while a current yield is the amount you generate if you sell the bond at present.
Convertible bond: This is a type of corporate bond that gives the ability to convert to equity. The types of such bonds are vanilla convertible bonds, reverse convertibles, packaged convertibles, and mandatory convertibles.

Advantages of Bonds

The bond market has a number of advantages over the other methods of raising money.

Benefits to issuers

Liquidity: For companies or governments undertaking large investments, the bond market has all the liquidity they need. This is because investors are always looking for a place to store their money and generate a yield.
Relatively Cheaper: Bonds are usually cheaper than alternative methods of financing e.g. bank loans.
Ownership: The bond market allows companies to raise capital while maintaining the ownership structure. For example, if you own a company and you issue a 5-year bond, after you finish paying it, you will retain ownership of the company.

Benefits to Investors

As an investor, there are a number of benefits that you get by investing in the bond market. These are:

Safe: Bonds are known to be safer than stocks and other securities. This is because it is usually very difficult for a bond issuer like a government to default on its obligations. However, before you invest in bonds, you need to look at their credit ratings. This is because in the past, a number of countries like Puerto Rico and Venezuela have defaulted.
Liquidity: There is a lot of liquidity in the market which means that you can exit your investments at any time.
Diversification: Investing in bonds allows you to diversify your sources of income.
Hedging: Expert investors are known to use bonds as hedging instruments. For example, if you believe that a company’s stock will decline, you can short it and then buy its bonds. This process is recommended to professional investors.
Fixed Income and predictable returns: As a bond holder, you will receive your interest payment periodically, which enables you to plan ahead.

Risks of Bonds

While bonds are known for their safety, they also come with a number of risks. Some of these risks are:

Interest Rates: This is the biggest risk that comes with bonds. When interest rates rise, bonds fall as investors move to other securities. Therefore, if you decide to sell a bond before maturity and the rates are high, you will sell it at a lower price than you paid for it.
Credit Risk: This risk is also known as default risk. The risk is that if a company or country becomes bankrupt while you hold its bonds, you will end up losing money. In 2018, US treasury yields rose as the US budget deficit increased.
Inflation Risk: If the rate of inflation rises fast, chances are that your returns will be overtaken by the rise in prices of products. Therefore, while you will get your principal at maturity, it will be worth less.
Market Risk: Markets rise and fall every day. Therefore, if the market declines as it did in 2008/9 chances are that you may lose money.

How to Invest in Bonds

As mentioned above, bonds are known for their safety. Therefore, the returns they offer are usually lower than those offered by other securities like shares. People invest in bonds for fixed income and diversification reasons. The traditional portfolio management strategy is to put 60% of funds in stocks and 40% of funds in bonds. With stocks, investors focus on quality companies from the developed countries like the United States and Germany. An easier entry into investing with lower initial deposit requirements is via brokers that offer stocks and indices CFD products.

To invest in bonks, the first step is to determine the type and the grade of the bonds you want to invest in. You need to consider whether you want to invest in treasury bonds, corporate bonds or municipal bonds. In this, you can decide to invest in one type or in a diverse group.

The grade refers to the safety or rating of the bond. Investment grade bonds are those of safe companies like Apple and Microsoft while junk bonds are those of leveraged companies like Netflix. Again, you can decide to invest in either investment grade bonds or in a diversified group of bonds.

After this, you would look to open a brokerage account and buy the bonds. Alternatively, you can invest in bonds ETFs. These are complex products that are made up of multiple bonds. For example, the Vanguard Total Bond Market ETF exposes you to US investment grade bonds while the PIMCO Total Return ETF invests in intermediate-term investment grade bonds.