Bonds have been the classic investment for people who don’t like taking risks. But even if investing in bonds is relatively safe, it is possible to lose money also on bonds. Here is a primer on how to invest in bonds.
Bonds are IOU (I owe You) issued by companies and governments. In other words, a bond is simply an acknowledgement that the issuer owes the holder of the bond money. The terms of the loan varies but typically interest, also known as the coupon, is paid regularly. Most bonds can also be sold on secondary markets. So called zero-coupon bonds don’t pay any interest, their value is derived from price paid by the bond issuer at maturity.
As a rule of thumb, the value of bonds has an inverse relationship to interest rates. If interest rates go up, bond values fall and vice versa. Bonds with fixed interest and zero interest will be more attractive when interest rates fall which means buyers are prepared to pay more for them.
Let’s look at an example with a zero-coupon bond, that is no interest, which matures in twelve months. If the price paid at maturity is $105 and the bond costs $100, a buyer would get 5% interest, ignoring transaction costs. The formula for the interest is (105-100)/100 which equals 5%. If interest rates would go up and new bonds were issued with interest greater than 5% a year, investors would prefer to buy them so the price of the bond has to go down in order to attract buyers. On the other hand, if interest rates would go down, the bond value would go up instead.
The same principle is true for bonds with fixed interest. Bonds with floating interest typically have their interest rate linked to a reference rate, such as LIBOR. Such bonds have less interest rate risk but are often issued by companies with low credit rating. Note that floating rate bonds are poor investments if interest rates go down, since the interest payments will be adjusted downwards. Increasing interest rates are on the other hand good for floating rate bonds. But if you want to speculate, high-yield bonds are generally considered a better bet than floating rate bonds.
High-yield bonds are also known as junk bonds. They are issued by companies lacking investment grade credit rating, this means that there is a risk of default. Since the risk of default is significantly higher than if the bond had been issued by an investment grade company or a government, investors expect a higher yield. The performance of high-yield bonds resembles more the performance of the stock markets than traditional bond markets. Therefore, high-yield bonds are seen as an alternative for investors who want better returns than traditional bonds offer but think that the stock market is too risky.
It is possible to buy bonds directly from the government but most investors use a broker, buy bond ETFs or bond funds. Note that brokers sometimes say that they trade bonds commission free but in reality they will add their commission on top of the price you pay for the bond. They just don’t call it commission. If you are only investing in low risk bonds such as government and high-grade bonds, using a broker is fine. But if you buy risky bonds, you probably don’t have enough money to build a bond portfolio with low risk. In that case, ETFs or mutual funds are a better choice.
Quantitative easing has made government bonds unattractive as investment so investors who used to buy government bonds need to look for new investment strategies. Of course, if you want to speculate in an end to quantitative easing government bonds could be a winner. But beware that government bonds are no longer safe investments. Governments are unlikely to go bankrupt but the return on their bonds could turn out to be dismal in the future.
The choice between ETFs and mutual funds is hotly debated. Both have advantages and disadvantages, but we certainly prefer to avoid bond funds with high administration costs. As a rule of thumb, bond ETFs have less overhead than bond funds. Some bond fund managers have been very successful but unfortunately they are the exceptions. If you want someone else to manage your investments and don’t mind paying extra for it, bond funds are the best solution. But if you have any aspirations of becoming a successful investor, ETFs are certainly worth looking into.
Given the risk that inflation will pick up we think that most investment portfolios should include very little bonds. Low-yielding government bonds certainly don’t look like a good investment at the moment. Things may very well change in the future but before we invest in bonds we would like to see an end to quantitative easing.