Investing in Bonds: A Step by Step Guide
Investing in Bonds: A Step by Step Guide
Investing in bonds is an excellent way to make money. It’s easy, simple and if you are careful, highly profitable. One of the greatest barriers to making money through bonds is the technical language that surrounds it. In reality, it’s very simple. With this step-by-step guide, we’ll guide you through the basics of bond investment. While we can’t promise to make you Jordan Belfort, we’ll certainly take you a step closer.
What are bonds?
So, what exactly are bonds?
A bond is a loan. If you buy a bond with a company, you are loaning them that money. Imagine there is a company called LEJ. By buying a bond at the price of £1000, you are loaning LEJ that full amount for an agreed period.
In return, LEJ promises to pay you interest on that loan throughout the agreed period. Once that period comes to an end, they’ll pay you back your original investment.
For example, if you buy a bond of £1000, agreeing a 5% interest rate every month over a year,
you will receive £50 a month. That’s £600 over the course of the year. Then, at the end of the period, you will get back the original £1000. Therefore, you will have made a profit of £600.
Too good to be true?
There is always a degree of risk involved. Often, the higher the risk, the greater the possibility of reward. By choosing your bond issuer carefully, you can tailor this balance of risk and reward to suit your personal needs. Which leads us to step #1…
Step #1: Understand the Difference between Unsecured and Secured
Investing your hard-earned money is serious business. Therefore, it’s important to conduct thorough research before choosing where to invest your capital.
The first thing you should know is that bond issuers can either be secured and unsecured.
Unsecured: If a bond issuer Is unsecured, repayment of the initial investment is only guaranteed by the issuing company. If they go bankrupt, you’ll lose your investment. However, you certainly shouldn’t ignore this option. Firstly, many unsecured bonds could be very profitable. You simply need to do your own research to work out whether you think it’s a good investment. The tools you need to do this are explained later.
Secondly, many unsecured bond issuers are very safe. Take for example government gilts. These are bonds issued by the UK government and are unsecured. However, given that its unlikely that the UK government will go bankrupt, these bonds are very safe. Interest rates are, however, low.
Secured: With secured bonds, specific assets are set aside so even if the company cannot pay out themselves, you will still receive back your original investment. These tend to come in the form of mortgage bonds and equipment trust certificates.
Step #2: Choose Corporate or Government Bonds (Or Both)
Generally, bonds are separable into two different categories.
Corporate Bonds: These are bonds issued by private business. They use them to develop their products, services and therefore, profitability. Here you will find the greatest variety; from very high risk to relatively low risk.
Government Bonds: These are bonds issued by national governments when a state needs to increase spending. These are renowned for being very low risk. Generally, however, interest rates are far lower.
Step #3: Assess the Bond Credit Rating
Bond credit ratings assess the likelihood that a bond will be repaid. Standard & Poor’s and Moody’s and Fitch are just two agencies that provide this service.
Ratings vary all the way from AAA to C. AAA is highly dependable and C means the bonds are in a state of imminent default. For first time investors, it is generally recommended not to invest in anything below BB- as these bonds are likely to be highly volatile
Step #4: Master the Technical Terms
It’s important to supplement your use of the bond credit rating system with a strong knowledge of some technical terms. These will help you to assess the profitability of different bonds. They may look and sound complicated, but these terms are actually very simple.
Yield to Maturity: Measures what the yield of the bond will be if everything goes to plan. In essence, this tells you how much money you will receive if the bond will be if it is held until the agreed end date. Remember, this in only an approximation.
Current Yield: This figure tells us how profitable the bond is compared to other bonds on the market. For example, imagine that two people buy a bond of £1000 but one with an interest rate of 10% and the other of 5%. The one with the 10% interest rate will have a higher current yield because, in comparison to similar bonds, the potential for profit is greater.
Nominal Yield: How often and at what rates you’ll receive interest payments.
Yield to Call: Tells investors what profit will be made if a bond is called (paid off) earlier than expected. For example, if you invest in LEJ, there is a chance that they’ll will pay off the bond early. Yield to call allows the investor to calculate what profit they could expect if this happened at a certain date.
Realized Yield: This tells investors how much they would make if they were only planning on holding a bond for a limited duration, rather than to the agreed end date.
Step #5 Get Investing
You now have all the tools at your disposal to make an educated investment. But remember, there’s no rush! Take your time, research, discuss with people in the business and then make your decision. After all, this is your capital. You need to use it wisely.
Below are some links to get you started. Although these sites are specific to the UK market, much of the information applies to markets generally.
Useful Links
Government Gilts Information: https://www.dmo.gov.uk/
Government Gilts through Barclays: https://www.barclays.co.uk/smart-investor/investments-explained/cash-and-bonds/introduction-to-investment-bonds-and-gilts/
Private Bonds: https://www.hl.co.uk/shares/corporate-bonds-gilts