Compared to shares, the word bonds may seem vague or complicated to some, but investing in bonds is actually a relatively safe and simple form of investing. Of course, there is always a chance that you will lose (part of) your investment, but unlike other investments, the risk here is generally quite low. But why is this risk quite low? And which type of bond has the lowest risk? If you want an answer to these questions, read the article below!
What is a bond?
Bonds are issued by companies or governments. They borrow money from you as an investor and you receive coupon interest during an agreed term. At the end of the loan period, the company or government pays out the borrowed amount. The interest earned on the loan can thus be seen as a profit.
So, bonds are always a loan with an agreed percentage of interest. This interest is usually paid out annually, but there are exceptions. Also, most bonds are being traded on stock exchanges and in general bonds have a fairly predictable character. Therefore they are seen as a relatively safe investment.
Difference between bonds and shares
A major difference between investing in bonds and investing in shares, is that by investing in a bond you do not own a ‘piece’ of the company. It is only a loan that puts the company in a position to grow. With investing in shares, on the other hand, you do buy a piece of the company and receive dividends as a share of the profit.
So the way that profits are made is different with shares or bonds, but that’s not the only difference. It is also noticeable that the price of bonds is often a lot more stable. Bonds have a lower volatility, which means a lower risk for investors. On the other hand, this does mean a lower return, because the golden rule remains: larger peaks and troughs are associated with a greater risk, but also a greater chance of gaining high returns.
The thinking behind investing in shares or bonds is therefore in some ways the complete opposite. Although in both cases it is about making a profit by investing your capital, with investing in shares this is based on the hope that something will be worth more in the future. With bonds however, it is based on agreements about the predetermined term. So, the length of the investment period has already been decided on beforehand.
Types of bonds
Because different conditions may attach to the bonds issued by companies, a distinction has been made in different types of bonds that investors can buy. The most common varieties are described below.
Zero coupon bond
Firstly, a zero coupon bond is a quite simple type of bond. As the name suggests, there are no coupons on this bond. Therefore the company or the government does not pay any interest to the investor. This is not a strange thing, because of course not all companies want to issue debt securities with interest. And if they do want to do so, the interest can vary from bond to bond.
But even without any interest, there is a definite advantage to this form of investing. Because of the absence of interest, a zero coupon bond generally can be bought with a large discount. Investors can buy them at a lower price and make profit because they are redeemed at the full nominal value at the end of the term. For example, if you buy a bond with a nominal value of 1000 euros with a discount of 100 euros, you will pay 900 euros but receive a return of 100 euros at the end of the term!
Perpetual and callable bonds
This form of investment has, as the name once again indicates, no predetermined term, which means an increased risk for the investor. After all, it is not certain when the lending company will return the money. Specific conditions are therefore especially important whith this type of bond.
Also, there are usually significantly higher coupon rates on a perpetual bond because of the risk the investor is prepared to take. If the company decides to repay the loan, it is called a callable bond. The company can sometimes choose to repay the debt before the term expires. Be aware that things can also turn out differently if the company finds itself in financial difficulty at some point. A company that goes bankrupt can, of course, not return the money.
Some companies choose to issue convertible bonds. With a convertible bond, companies offer the possibility to, after the end date, convert the bond into something else. For example, it could be converted into shares in the company. The advantage for companies to issue convertible bonds is that they do not have to pay any money back and the company’s share price can rise because of this.
The coupon rate on this type of bond is usually lower, because the actual return is in the shares that the return is converted to. In addition, the aforementioned situation of a rising share price automatically results in a higher value of the convertible bond. And that is how the profit is made!
Another type of bond we would like to mention is the subordinated bond. This is a type of bond in which those who invest in it are the last people entitled to receive repayment of the loans. Other creditors are first in line when it comes to the repayment.
Companies that issue subordinated bonds usually do this at a higher coupon rate. If everything goes according to expectations, you will make more profit at the end of the day than with regular bonds.
Last but not least we would like to explain what premium bonds are. What are premium bonds? Premium bonds, also called ‘NS&I premium bonds’, is a way of saving which is very popular in the UK. These bonds are also solely issued by the National Savings and Investment (NS&I), a state-owned savings bank in the United Kingdom, and are very different from other bonds.
Unlike other types of bonds or types of investing, with premium bonds you are entered into a monthly prize draw. With this prize draw you can win between twenty five and one million pounds. Of course, the disadvantages of this are the extreme low odds. If you do not win an amount at the prize draw, you will not earn any money because there are no regular returns with this type of investment.
Why invest in bonds
As described above, there are several types of bonds that investors may encounter. Which one you prefer is of course up to you. Often you will only have a limited choice if you want to invest in a company by means of bonds. The issuing party, so the company or government, will decide what type of bond they want to issue and under what conditions.
If you are looking for a way to earn more return on your savings than you get through a bank account, you may want to consider bonds. The advantage of bonds is that the risk is usually lower than with other forms of investment such as shares. This makes it a relatively ‘safe’ way of investing.
What is the risk of investing in bonds?
As an investor in bonds, you face several risks. For example, there is a chance that the company issuing the bond will ultimately be unable to repay the loan. This can even happen to governments issuing bonds, although the chance is much smaller than it is with companies. So, as a bondholder, you run the risk of losing your investment. But this risk is much smaller than when you invest in shares.
In addition, it can also happen that during the term of your bond the exchange rate changes. Although this does not affect the nominal value you get back at the end of the term, it does have an effect on the interest rate. To assess the risk of a bond, you can look at its rating. The higher the rating, the higher the creditworthiness and therefore the likelihood that the company will eventually repay the interest and loan.