Most investors consider that investments in bonds are an important part of their overall financial strategy.
Here we will look at the bond basics and why this is the case. However, this is for your information only, and you shouldn’t take it as investment advice.
If you would like such advice, then please talk to your financial advisor.
First we will look at exactly what is meant by a bond and why investing in bonds is often recommended by financial advisors as a key element in a properly diversified investment portfolio.
Next we will address the basics on how bond investments can be evaluated and some of the strategies that tend to be used.
Finally, we will look at investing in a similar asset class to bonds, peer-to-peer investing.
What are bonds?
Investments in bonds are essentially loans; when you purchase a bond, you are essentially lending an organisation money.
The organisation might be the government, a business, an investment company, in fact any entity that wishes to borrow money.
The actual bond is essentially a security on that loan, or a loan note or IOU. While the analogy between loans and bonds is a useful concept, there are significant differences between the two.
With a bond the organisation will agree to repay the principal after a fixed period, for instance after 5, 10, 20 years or longer, along with interest at a fixed rate; the bond, however, is a tradeable item.
Your investments in bonds can be sold to another party so you are not obliged to wait the full term for the bond to mature.
While in certain circumstances loans can be sold, under normal circumstances they are not tradeable and they last for the full term.
The benefits of investing in bonds
Investments in bonds are usually just one part of an investment portfolio; most investment portfolios also include stocks and cash investments.
The relative proportions of each of these tends to be a personal choice that reflects individual investment objectives as well as the investor’s attitude to risk.
For instance, investments in bonds are usually considered carry a low risk, while investing in stocks carries a higher level of risk. Again, for further advice on this you should ask your financial advisor.
While interest payment strategies vary, generally bonds pay out interest two times a year, and as the interest rate is fixed your income from your bond investments will be predictable.
In fact, one of the main motivations for investing in bonds is to provide a regular income while preserving the capital value of your investment.
The basics of investing in bonds
There are several factors that are usually taken into account on bond investments. These include:
As already mentioned bonds tend to carry a lower risk than stocks, but all investments have some degree of risk and some bonds are riskier than others.There is usually a close risk between the risk of specific bonds and the returns; as you might expect, the low returns are usually reflected by lower levels of risk and high returns are associated with higher risk.
The price of a bond reflects a range of factors.These include amongst others: supply and demand; the interest rate; the credit rating of the issuer; bond liquidity; and the maturity term.When bonds are first issued generally they are sold at their face value.When these are subsequently traded their price will vary according to a range of market forces including: the prevailing interest rate; the current economic climate; the ongoing credit status of the issuer; along with supply and demand.
Bonds may sell at a premium, in other words for more than its face value; or it might be discounted; in other words, it will cost less than its face value.
- Interest rate
While as mentioned bonds usually pay interest at a fixed rate twice a year, but this isn’t always the case.Bonds may pay out floating interest rates which are adjusted according to a parameter such as the prevailing London Interbank Offered Rate (LIBOR).Some bonds are called “zero coupon” bonds and don’t pay out any interest until they mature, at which time they repay the principal capital along with all the interest, which usually is compounded annually or bi-annually.
Such bonds are heavily discounted in that they are sold for considerably less than their face value.
As an example of this, should your investments in bonds include a bond with a face value of £10,000 that matures after 20 years and you pay £2,500 for it, the discount of £7,500 represents a compounded interest payment at an interest rate of approximately 7%.
Thus,when deciding if investing in zero coupon bonds is sound, you will need to make this sort of “future vale” calculation. Note that zero coupon bonds tend to be fairly volatile.
This is the actual date on which the bond matures and the capital (face value) is repaid.Shorter tem bonds generally have lower interest rates and are considered to be lower risk, with medium and long term bonds having higher interest rates and higher risk.When investing in bonds it is usual to balance your investment portfolio to include bonds of various terms.So far we have considered that maturity dates are fixed, but that isn’t always the case.
Some bonds have a “call provision” that allows or demands that the bond is redeemed before the maturity date should certain market conditions occur, for instance should the interest rate collapse to a specified level significantly lower than when the bond was issued.
Similarly, a “put provision” empowers the investor to sell the bond prior to its maturity date.When investing in bonds it is important to check whether these apply.
The yield is simply the return on the bond as a function of the price paid and the interest earned; generally, it is stated as basis points (bps) where a yield of 500 bps is equivalent to a return of 5%.Current yield is the annual return, while yield to maturity is the total yield the bond will earn from the date you purchase it until its maturity date.
Bond Price Fluctuations, yield and maturity
As stated already, the price of bonds varies depending on factors such as prevailing interest rates and capital markets.
When interest rates fall, bond prices tend to rise and vice versa. Longer terms bonds tend to be more affected by interest rates changes than shorter term bonds.
These changes can be tracked by using “yield curves” that compare the yield of similar bonds with different maturities.
When investing in bonds it is important to look at the current yield curves that are reported in the press on on the web.
How to invest in bonds
Investments in bonds have several purchase options. You may choose to invest in individual bonds to develop your bond investment portfolio, or you can invest in bond funds.
There is a range of bond funds which are generally managed by professional investors to achieve specific investment objectives. Alternatively bond funds may be passively managed and adjusted to follow a market trend such as a specified bond market index.
Unlike individual bonds, bond funds don’t have a specified maturity date. With an “open ended mutual fund” you can buy or sell a share in the fund any time you wish, and the price fluctuates in line with the current fund holding.
Peer-to-peer – an alternative to investments in bonds
An asset class similar to investments in bonds is investments in peer-to-peer lending. The overall objective of both forms of investment is to generate an income by lending money to another party and receiving a return on that loan.
However, with peer to peer lending you can expect higher returns than you would obtain with all but the highest risk bonds. Naturally peer to peer lending also carries a higher risk than many bond classes.
Peer-to-peer investing has grown from being a niche market just a few years ago to becoming a major player demonstrating exponential growth; such is its power that even government agencies and major banks are becoming involved.
Depending on the level of risk investors are willing to take, returns of anything between 5% and 12% are achievable, even allowing for the fact that a proportion of the loans will default.
With a range of alternative peer-to-peer platforms in which to invest, there is ample opportunity for investors to diversify their peer-to-peer investment portfolio.
While most peer-to-peer lending platforms are based on fiat currencies, and alternative model that is proving to have some significant advantages is bitcoin peer-to-peer platforms such as Bitbond.
No longer is bitcoin out there somewhere on the fringe, today it is becoming progressively mainstream.
Advantages of investing in Bitbond is that it enables you to lend to small businesses and entrepreneurs anywhere in the world as bitcoins have no national boundaries; there is no delay in transferring bitcoin funds, they are transferred literally instantly; and as no bank account is needed to process the transaction fees are non-existent for investors and only nominal for borrowers.
With potential returns as high as 11% it might make a worthy addition to your overall investments in bonds, so why not mention it to your financial advisor?
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