Investing in Bonds

Investing in bonds is generally seen as a way to generate regular income without taking on too much risk. It also provides an alternative way of making profits from long term market trends in fixed income markets.

Bond interest rates are constantly changing, so by recognising key opportunities and acting on them it is possible to make significant money in a reasonably predictable way. The following tricks will help you make the most of your bond investment strategy, however do take note that these tricks don’t constitute investment advice, they are simply tricks that you might care to investigate.

Tip 1 – Define your objectives

Consider exactly what it is you want to achieve from investing in bonds. It is entirely different from investing in stocks, though of course there are parallels. When investing in stocks you are purchasing a share in that company, but with bonds you are lending money to the company or organisation.

The bond has a monetary value, the amount you pay for it, and that sum, the principal, will be returned to you when the bond matures. You will also receive interest on your loan which will be paid after a specified period, for instance monthly, twice a year, or annually.

With stocks the return on your investment depends on how the company prospers. When it does well the value of your investment increases and when it fares badly you will see a loss. You can also expect a dividend which will also depend on the success of the company. Stocks can be volatile and generally investing in them is a long term investment for people who are willing to accept short term risk, though skilled investors and day traders who are not averse to risk can leverage that volatility to make serious money in the short term.
Bonds don’t carry that level of risk, apart from in certain markets. You are almost certain to get your money back and profit from the interest. They provide a predicable income stream which is better than you would get from a bank; you achieve reasonable yields without the volatility of the stock market. Bonds are also a better investment than stock if you think you will need the money in the near future.

Diversification is the name of the game. Decide on your objectives, and the level of risk you are happy with.

Tip 2 – Understand bond interest rates

To make the most out of investing in bonds, it is important to understand how bond interest rates work in relation to risk. There are three components:

The risk free interest rate, typically the yields on inflation protected government bonds
The current estimate of future yearly inflation, which can be difficult to pin down
The credit risk premium, in other words the premium you are willing to accept in order to cover the risk that your investment won’t be repaid

While you can make money by focussing on the first two of these, risk free interest rates and inflation, predicting how these will change over time is very much a finger in the air exercise. Even if you were to be fortunate enough to get it right, the gains you might make would be so low that it would hardly be worth the effort.

The most important element is credit risk premium which is far more volatile than the other components. To restate what we mean by this: it is the minimum amount of money that you are willing to accept as a return on a risky bond, over and above the amount you would receive on a no-risk bond such as an inflation protected government bond, in order to persuade you to invest in the risky bond rather than the no-risk bond.

Credit risk premiums are a function of the economic cycle. There are many kinds of credit risk; for instance mortgage backed debt along with a wide range of corporate debts. Different kinds of bonds have different risk premiums.

Clearly AAA rated corporate bonds are far less risky than junk bonds, and the quality of mortgage backed bonds can covers a wide spectrum of risks.
When the economy is strong and thriving companies are far more likely to repay their debts and as a consequence credit risk premiums are generally low. In times of recession companies are far more likely to default and thus the credit rate premium is higher.

How to use this to your optimum benefit isn’t quite as intuitive as you might think, which moves us on to our next trick.

Tip 3 – The economic cycle – don’t always follow the crowd

There is a huge discrepancy between actual default rates and bond prices. The probability of default is overstated, so even taking account of defaults, you can make far more money by investing in bonds with high credit risk premiums than you would be able to by investing in no-risk bonds.

As we have indicated, however, credit risk premiums change with the economic cycle. Clearly investing in bonds to make the most of these fluctuations in credit risk premiums is a desirable strategy.

The economic cycle has several turning points which can have a profound effect on the bond market. The four stages are:

Expansion during which time economies are booming, unemployment is falling and economic output is growing. There is pressure on prices and interest rates that begin the cycle low begin to rise. This is when investment grade bonds along with high yielding bonds are the best performers.
Peak, at which time maximum output and employment has been achieved. Interest rates will be at or close to their highest level. Unemployment in certain sectors begins to increase. This is the time when high yielding bonds are the top performers.
Contraction, when output decreases and unemployment rises. Inflation rates start high and fall. During this phase government bonds perform better than corporate bonds.
Trough when unemployment is highest with low inflation and interest rates. Here investment grade bonds are the best buy.

Looking at default rates published by Moody’s, during the 2008 recession when GDP was declining by 5%, default rates soared to 13%; and when in mid-cycle with 2.5% growth, default rates are typically just 2% to 3%.

The trick is to think ahead and not necessarily go with the crowd. While at the peak of the economic cycle everybody is putting their money into high risk bonds for higher returns, the wise investor should invest in non-risk government bonds in anticipation of higher credit premiums and falling bond prices.

Conversely, at the trough risk premiums are at their minimum and the optimum strategy is to invest in high risk bonds. The important takeaway is to avoid credit risk when everybody else is embracing it, and to take credit risk when everybody else is shunning it.

Tip 4 – Investing in bonds to build a Bond Ladder

A primary reason for investing in bonds is to generate a long term income rather than make a quick profit, and the ideal way of doing so is by building a bond ladder. Essentially this involves building a bond portfolio that provides exposure to the best rates currently available while reserving the opportunity to benefit from better rates when they occur.

You should design your bond ladder so that your investments mature at regular intervals. For instance you could invest in one year bonds, two year bonds and so on up to five year bonds, spreading your investments evenly. When your one year bond matures, you should invest in the best five your bonds you can find. The following year when your two year bond matures you should do the same and so forth ad infinitum.

The advantage is that you will eventually have all your bond investments in five year bonds thus enjoying the best rates, while one of your investments will mature every year. If the markets remain constant, your interest rates will still increase each year for the first five years, and each year you have the opportunity to benefit from improving rates.

You can also adjust the balance of risk across your bond ladder to even out the ebbs and flows of the economic cycle taking account of the advice given above.

Tip 5 – Buy and hold apart from when the yield curve suggests otherwise

While investing in bonds is generally a low risk strategy, the price of long term bonds can be volatile, for instance if it is paying 4% and interest rates are 5% then it is worth far less than if interest rates were 3%.

While you might like to use that price volatility to make a profit, deciding on the optimum time to sell is fraught with difficulties. A better strategy is to buy and hold, meaning you only have one decision to get right: when you should buy. Trying to time the bond market is a strategy best left to the experts with big positions to move.

Generally you should forget about short term variations in the bonds you hold; apart from the small risk of default, you will receive your interest during the period and the bonds face value on maturity. But like all rules, there are exceptions to this.

A yield curve is simply a chart that compares bonds of similar credit quality in terms of their interest rates and maturity dates. When the general economy and interest rates are stable, bonds with short times to maturity will have the lowest yield as the market risk of holding them is low.

Market risk is higher for long term bonds, with additional risk relating to greater uncertainty regarding interest and principal payments, thus they have higher yields.

The relationship between yield and maturity is fairly steady up to 10 years, but after then it flattens out suggesting that there is little or no benefit in investing in bonds with longer that 10 year terms. In cases where the yield curve is steep there is greater compensation for investing in long term bonds, so consider these for your bond ladder.

When the yield curve is flat you should focus on short or intermediate term bonds as there is no compensation for the extra risk of long term bonds. Generally a flat yield curve is a transitory stage with things likely to change in the short term, though the direction in which they will change is often an unknown.

When the slope of the yield curve is negative (descending) so that bonds maturing in the short term have higher yields than long term bonds, the economy is likely to be moving into recession. While you might consider that investing in bonds that mature in the short term is the best strategy, this isn’t necessarily the case.

Negative yield curves tend to be short lived, and short term yields can quickly decline, with the risk that you might have missed the chance to lock in current long term interest rates which are likely to fall even further. By all means buy short term bonds if you need the cash in the short term, but for long term investments focus on 5 to 10 year bonds.

Tip 6 – Invest in bonds when interest rates fall

While it is fairly straight forward to make money by investing in bonds when interest rates are rising, you can also make money when interest rates fall; here’s how:

Don’t rely on cash – during times of low interest rates many people prefer to keep their money in the bank or in low yield money market funds while they wait for interest rates to increase and bond yields to improve. This isn’t always a bad strategy, but if low interest rates persist as they have in recent history, the strategy could prove expensive as you are missing out on the slightly higher returns of bonds. The longer you wait, the higher rates must rise to compensate for your loss and the risk that they might fall even lower. Typical returns from UK cash ISA accounts are between 1% and 1.5%.
Invest in savings bonds. These are available as fixed rate bonds which pay a set interest rate that is higher than you would get in a bank and mature after a fixed term, or tracker bonds that are tied to an index such as the BoE interest rate. Currently a five year savings bond might pay around 3% interest a year.
Sell some of your bond holdings to make a capital gain and invest the proceeds in alternative investments that are potentially higher yielding.
Buy kicker bonds. These are bonds that are callable which are priced on the assumption that they will be redeemed at a specified date before they mature. If the issuer decides not to call the bond, then the yield increases (“kicks”) accordingly. The yields tend to be higher than normal bonds with a similar maturity.

During times of low interest rates that are always concerns that they are about to rise in line with rising inflation. Concomitantly, the value of long term bonds would decline significantly.

This apprehension can suggest that the best strategy is to focus on short term bonds as they are considerably less risky. However doing so sacrifices the higher yield of longer term bonds along with the higher overall yield due to compounding interest.

Again, you shouldn’t focus on the current market value of your bond, as your bond ladder should ensure that you ride out any hills and troughs as long as you hold your bonds till maturity.

Finally – an alternative strategy

These 6 great tricks to start making money by investing in bonds should help your investment plans. There is, however, an alternative way that provides good returns is to invest in Bitbond, the P2P bitcoin lending platform that connects investors and borrowers. Bitbond provides a means to earn better returns than you would find at a bank. Although there is a higher element of risk, this is compensated for by the additional potential income.

Another attraction of Bitbond is that you can invest as little or as much as you wish and there are no international boundaries. This opens up the market globally allowing you to take advantage of some of the high interest rates found in certain countries. It isn’t unusual to achieve rates of 15% or more depending on the amount of risk you are happy to take.

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Chris Grundy

Head of Marketing at Bitbond GmbH

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