When people talk about investing, they are often talking about the stock market but there are other ways of investing your money. One of the best ways is to invest is in bonds but how do you make money by investing in bonds? Let’s answer this question.
A bond has a duration of 10 to 30 years. Each year, you will get paid out a certain percentage of interest. At any time, you can sell the bond either for a profit, a loss or at the same price that you bought it for. You can also hold onto it and receive payments until the end of the bond and then sell it back to the company or government agency.
There is a lot more to investing in bonds than just how to make money and in this article, we are going to take a very in-depth look at investing in bonds. So, for everything you need to know, keep reading.
What Are Bonds?
When doing your research for this, you might often find yourself getting frustrated because people tend to give you lengthy answers that only complicate the subject and make it harder for people with no experience to understand. While we will go in-depth into what bonds are, we will first give you a short and simple answer.
A bond is nothing more than something that is used to acknowledge that you loaned money to a government, trust, or corporation. A bond often means that you will get paid your money back over a length of time with interest. In short, a bond means that you are a lender and the bond is an agreement.
Different Types Of Bonds
Now that we have the short answer out of the way, I would like to just take a minute to explain the different types of bonds that you get. I highly recommend that you read this section before moving on to another so that you can fully understand the rest of the subject in this article a lot better.
We will only focus on four bond types in this article.
For this section, we are going to acknowledge that before investing in each Bond type you should know that the bond needs to be profitable and the interest rate needs to benefit you more than if you were to invest your money in a savings account. Now that we have mentioned this, we won’t have to mention it every time we speak about a bond.
Let us take a quick look at what municipal bonds are.
A municipal bond is issued to someone who lends money to the local government. The bond acts as a security to the investor or lender as a guarantee that they will get their money back with interest.
Before you invest in municipal bonds you need to make sure that you will make a profit. A lot of people decide to take municipal bonds when they know that they will make a profit but when they also want to help out their communities.
Investment Grade Bonds
Investment-grade bonds tend to be some of the most commonly issued ones. Let us take a quick look at why this is.
Investment-grade bonds normally have a lower interest rate so they don’t return as much profit but they are lower risk because they have great credit ratings. This means that there is a lower risk of default by the loan or investment recipients.
The people who give these bonds their credit rating are Moody’s, Standard & Poor, and a few others.
Ok, so we are about to talk about treasury bonds which might take some time. So, I suggest either getting a pen and paper ready or bookmark this page so that you can use it as a reference in the future when making your decisions. For now though, let’s take a look at what treasury bonds are.
A treasury bond is issued by the United States federal government to the lender. The terms of a treasury bond can be anywhere from 10 to 30 years and the lender is paid interest every six months until the bond matures.
The best way to look at this is if you were to take $100,000 in cash and keep it in the safe for 30 years and then take it out to use it, what would its value be? Well, that $100,000 will be worth a lot less than what it was 30 years ago.
If however, you were to have invested that $100,000 in a bond the outcome should be different. Not only would you have been paid every six months in interest, but you would also be paid out the value of that bond which would be relative to the time. So, the value of that $100,000 would have increased instead of decreased.
Don’t let the name “junk bonds” fool you as it is possible to make a lot of money with these. That being said, there is a reason why they are called junk bonds and we are going to take a look at that right now.
A junk bond is a bond that has the potential to yield high rewards but it also has the highest risks that come with it. Basically, these bonds are ones that are most commonly hit with defaults by the recipients of the investment or loan.
There are a lot of factors that can attribute to your bonds not being profitable and it could be anything from events within a company to external factors such as politics. At the end of the day, we can summarise this by saying “junk bonds are high potential and high risk at the same time.
Remember… You can also lose money investing in bonds, so check out 18 Ways You Can Lose Money With Bonds & How to Avoid Them
How you Get Paid from a Bond Investment (Fixed Income)
I understand that one of the most burning questions that anybody who is looking towards investing has is payment.
Whenever someone is looking at the options, the question is, how are they going to get paid. With bonds, there are two types of ways that you get paid. The first is your interest payments and the second is the profit that you get from selling those bonds.
In this section, we are going to focus on a fixed income which would be the interest payments that you receive every 6 months from owning the bond.
When we talk about returns, we are not going to talk about junk bond returns because those are more erratic. As we mentioned, those often have a high risk and high reward ratio.
For most bonds, you are looking at approximately 4 and 6% per annum on your investment or loan. Unlike with the stock market where your income can increase or decrease depending on the market, with a bond, you earn a fixed income and a fixed percentage on your investment.
How Often You Are Paid
Your payments are received every six months, so, twice a year. If you have invested a significant amount of money into bonds, these biannual payments can be substantial enough for most people to retire if you know how to handle lump sums of money.
It is important to note that some bonds have different terms. So, their payment arrangements could differ.
Bonds can gain asset appreciation. So if you purchase a bond, then the value of your investment goes up, you can then sell for a higher price than you bought. The factors that affect the bond price are:
- Credit rating of the bond issuer, if the borrowers credit rating increases the more likely you are going to be paid until maturity.
- However, if prevailing interest rates on a newly issued bond go down, so will your capital in the investment.
The Difference between Investment Grade And Junk Bonds
Earlier on in the article, we spoke about junk bonds and investment-grade bonds. These two types of bonds are very common, especially for people who are not looking to hold on to their bonds for very long periods of time. In this section, we are going to look at the difference between these two.
The main difference between these two types of bonds is:
- Investment-grade Bonds have a low risk and low reward ratio.
- Junk Bonds have high reward potential but they also have a very high risk of defaulting.
These bonds are often graded by investment firms such as Moody’s and Standard & Poor. Investment-grade bonds often have a higher grading while junk bonds have a lower score from these firms.
The best way to understand this is to say:
- Junk Bonds are offered by companies/establishments who expect growth but whose books do not look so great at the moment. They could either grow or they could fail.
- Investment-grade bonds are from companies/establishments who do not need the money as badly and whose books are in great condition or at least stable. These companies have a good credit rating from investment firms.
What Makes a Good Bond Investment
So, I feel like we have discussed, pretty in-depth, what a bond is and now we can move on to a few more important details about bonds. In this section, we are going to talk about what makes a bond a good investment and we are going to discuss this in correlation to the two main types of investment goals.
Any bond that is rated as BBB or above is an investment-grade bond and these are typically the best types as they offer a fixed income over their lifecycle. They also offer some surety concerning the value of the bond over time.
A bond that might increase in value during its maturity process is a good investment but before buying the bond, you need to do your research on the establishment from which you are taking the bond out first.
Basically, what we did above is we referenced a bond that would be considered investment-grade but ultimately your end goal is what will determine whether or not something is a good investment.
For someone with short-term goals, you could look towards junk bonds. However, I must warn you that you do need to put a significant amount of research into a junk Bond before buying into it.b before investing.
Not everybody has the same investment goals so it is important for you to sit down and consider what exactly you want to get out of a bond. What I can say is that most treasury and investment-grade bonds are good additions to any portfolio and that leads us into our next section.
Portfolio Diversity: Bonds And Stocks
We are now going to talk about how bonds should fit into your portfolio and we are going to consider these things when talking about it: First, your age and then whether the market is a bull or bear market. Before we jump to age, let’s look at what a universally good portfolio should look like.
In a Bull market, you should have 70% of your portfolio in bonds and 30% in Stocks. However, during a Bear market the opposite is true, because stocks are generally undervalued.
If you are between the ages of 18 and 32, then you could definitely start out with a portfolio that leans more toward stocks, and then as you get older, it is wise to start investing more in bonds, specifically treasury and investment-grade bonds.
This means that while 30% of your portfolio has the chance of exploding with the stock market if it increases, you also have 70% in a safer and more fixed bond. This is what will contribute towards a fixed income and this will be highly beneficial for when you enter retirement.
What Affects The Price Of A Bond
If you have been trying to learn as much as you can about bonds for quite some time and maybe you have been watching a few bonds that you are interested in. You Might have noticed that those bonds fluctuate in price. I would understand why you might be concerned but don’t worry, we are going to discuss what affects the price of a bond.
The price of a bond can be affected by the following:
- Interest rates
- Bond Rating
Now, let’s take a look at these factors a little bit closer.
The reason why this is first on the list of things that we are mentioning is because it is probably the biggest thing to factor in. It is important to remember that when we are talking about interest rates of bonds, it means the amount of interest that you get paid out.
If a bond pays less interest to the person who owns it, that means that that bond will be less appealing to investors. So, according to the logic of supply and demand, because this Bond will now be less in demand, the prices will decrease.
Again, early on in this article, we spoke a little bit about bond ratings. These ratings are given out by investment firms such as Moody’s and they can have a severe impact on the price of a bond. You can actually also connect this to the interest rate.
The higher a bond is rated, the lower the interest rate will be because this bond will now be more desirable to long-term investors who prefer a guarantee over anything else.
Changes in bond rating can have an affect on the bonds overall value. A higher bond rating means more security and lower risk, long term investors prefer these bonds making them in high demand.
In terms of the economy, there are predictable causes as to why a bond price may rise or fall, and then they are unpredictable situations. Let’s take a look at these two in a little bit more depth.
Something that is more predictable is something like inflation. While we cannot 100% correctly predict how inflation will rise every year, we can use previous data to make calculated predictions. So a financial expert could predict how a bond’s price will fare in the next few years.
Unpredictable circumstances include things such as politics. You might have a situation where the US goes through an election and you have a surprise candidate win that election who investors are not happy with.
Think of it as the stability of a country. It is impossible to predict what other countries might do to the United States and likewise, it is unpredictable how the United States might handle its foreign affairs.
One important thing to note is that if you live in the United States of America you live in a rather stable country. This is because, without getting into too much politics, the political system is designed in a way that one party can never hold too much power.
A brief section on stocks vs bonds.
Now that we have discussed your portfolio diversity, let’s take a look at some of the benefits and disadvantages of both stocks and bonds. This section will be more of a comparison than anything else.
Advantages And Disadvantages Of Bonds:
- Less volatile than stocks
- Less risky than stocks
- Better for fixed income
- Better for retirement
- Less return on investment
- Still has a chance to decrease in value
Taking a look at the advantages on this list, you can see that we are somewhat justified in saying that, for retirement, you should look more towards bonds than stocks.
But you should still consider devoting a small part of your portfolio to the wider market as it can produce accelerated returns.
Advantages And Disadvantages Of Stocks:
- Better chance of increasing your wealth
- Can be used for fixed-income
- Not as good as bonds for fixed income.
- Not as good for retirement because it is volatile
When it comes to stocks, you can generate an enormous amount of profit in the right conditions. Those conditions are not common, usually, stock market investor will wait years for the right price to enter at.
And now, in the section of disadvantages, you can again see why we recommend the portfolio diversity ratio that we do. Stocks are a lot riskier than bonds.
If you have a portfolio that has more stocks in it, you run the risk of those stocks crashing and this is life-changing especially if you are hoping to use your portfolio for a fixed income during retirement.
For How Long Should You Hold Your Bond?
Every Bond that you hold is different and the length of the bond can be anywhere from 10 to 20 and even 30 years. So, in this section, we aren’t really going to talk about the maximum amount of time that you should hold the bond but rather, we will discuss how long you should hold your bond before trying to sell it.
When purchasing a bond, you should never sell it within the first 5 years. That is the minimum threshold that any financial expert will tell you. If, after five years of being paid your interest, you wish to sell it, you need to factor in how much profit you are going to make and if, in a rare situation, you are going to lose money.
There are certain types of bonds, such as junk bonds, that are generally held for a year or two years only. This is because junk bonds will get sold once they start rising to a decent profit. At the same time, people don’t want to risk not only missing out on that profit but the unlikely situation where the value of the bond might fall significantly.
Investing in bonds is a great way to build savings in preparation to retirement, check out our 9 Best Investment Bonds to Save for your Future!
The Lifecycle Of A Bond
A bond has a life cycle and depending on what type of Bond it is, that life cycle can be different. Generally, when an individual invests in a single Bond they tend to hold on to it but the larger the value of a bond the more technical its lifecycle can become. That is what we are going to look at in this section.
A bond will have three phases of its life cycle. Let’s take a look at what those three phases are.
- Primary Market
- Secondary Market
I think just highlighting the three phases is not enough. So, let’s go in-depth into what each of these phases within the bonds life cycle actually means.
The first phase of a bond’s life cycle is where it is issued by the company or government to the lender. The size of this Bond will determine whether or not it enters the secondary market.
The secondary market is a little bit more complicated to explain but I will try my best. It is important to note that if an individual holds an entire bond, often they do not go into the secondary market.
Large bonds that are held by certain investment firms, agencies, or even trusts will sometimes be split up and sold on the secondary market. Basically, the bond becomes a sort of stock.
In the secondary market, the bond is usually held for short periods of time by a lot of different individuals.
People can often hold onto a bond hoping for a few decent payouts before selling their share or you can use these bonds as a way to make a profit but in order to do this, you need to understand how the value will be affected in the future. The basic rule applies here which is to buy low and sell high.
Maturity is when the bond is reaching the end of its life cycle and it is at this point that you will sell it back to the establishment or it will be refinanced.
Either your capital will be returned to you, or you will be given the chance to extend the lending period.
How These Three Phases Affect Your Bond’s Price
This is a question that I get asked quite a lot and I think what people are trying to ask is whether or not you can sell your Bond throughout its term during the primary and secondary market before it gets to its maturity level.
You can sell a bond at any point through its lifecycle. If there is a profit to be made, feel free to take it.
However, if you can sell the Bond for profit after receiving a few interest payments then it won’t be too much of a bad thing to sell it but as we mentioned above you should always try and hold onto a bond for at least 5 years.
That brings us to the end of this article and I hope that you can walk away from it without having any more questions about how bonds work. That said, a good investor will always have questions to ask.
Bonds are a great investment for anyone especially when you start wanting to build up towards your retirement. If you have any more questions about investing, feel free to check out some of the other articles so that you can get a head start in your financial future.