What are Bonds and How Do They Work? How to Invest with Bonds as a Beginner

How to Invest in Bonds as a Beginner
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You often hear “stocks and bonds” in the same breath. And while I’ve covered stocks – or specifically index funds – quite a bit here on my website, I have yet to discuss bonds. (My name is Bond, James Bond…). And, all 007 jokes aside, there is really nothing super mysterious about bonds.

In fact, they’re an incredibly safe method of investing. Although, that isn’t to say they don’t have some cons either. Today in this article, we’ll go over the basics of bonds: what they are, the good, the bad, and why you might want to add them to your investment portfolio.

What are Bonds

When we talk about bonds, these are loans from an investor – i.e. you – to a borrower, such as a corporation or government. The borrower uses the funds to support the company’s activities. At the same time, the investor earns interest from the investment. A bond’s market value might also change over time. Look at it this way.

If you have ever given money to a relative or a friend, you have likely invested in a bond. The difference is that there was no official agreement between friends and family members. It was through an informal understanding. In the financial world, a bond is just a loan that you offer to someone in exchange for interest. Bonds are a formal legal agreement between the lender and the borrower.

It is permissible to legally take possession of the borrower’s property and sell it to recoup your investment if they filed for bankruptcy. This is why bonds are thought to be a safer investment than stocks. Stockholders will only profit if the company does, but they’ll also lose their investments if there is no capital gain or the firm goes bankrupt. That is only the tip of the iceberg.

Difference between Bonds and Stocks

The major difference between a stock and a bond is that a stock is a PERSONAL investment while a bond is a LOAN investment. When an investor buys stocks, they become part of the owners of that business. If a shareholder purchases a bond, you are making a loan to the corporation in return for quarterly interest payments.

If a firm files for bankruptcy, stockholders have no legal remedy. However, bondholders can still recover part of their investment by selling off the company’s assets. Stockholders will get rich if the company has huge financial success. If you are a bondholder, you will only get the interest and principal payments, and not share as much in their growth.

When investing, it is generally better to put money in stocks rather than bonds. Consider Amazon. Amazon issues both bonds and stocks. If you admire Amazon as a company, you can purchase Amazon stock or Amazon bonds. You own a piece of Amazon if you purchase shares. On the other hand, buying Amazon bonds makes you a lender to Amazon. But its corporate bonds are currently at 2.7%.

It’s reasonable to assume that investing in a company’s stock will usually be far more profitable than doing so in its bonds. But it comes with downsides, too.

Difference between Bonds and Stocks
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How do you pick the bonds to purchase?

The two primary factors you should consider when buying bonds are creditworthiness and yield. Your willingness to trust the borrower to pay their debts depends on their creditworthiness. When investing in bonds, creditworthiness should be your TOP priority. As long as the borrower is credit qualified, you are legally assured to collect both the principal repayment and the interest.

As a bond investor, you should always do your due diligence on the borrower. Also, make sure you only invest in creditworthy bonds. If the borrower goes bankrupt, you either get your money back or not. To ensure that it is creditworthy, check its credit rating.

What is credit Rating?

Credit ratings are scores that are calculated and published by independent third-party agencies that help you determine how trustworthy a borrower is. Triple-A is the highest rating for a bond. It is thought to be an extremely safe investment with almost no chance of default. The lowest rating for a bond is a C. This indicates that it is already in default and at the bottom of the scale.

As for the intermediate ground, everything Triple B and above is regarded as investment grade. And anything below it is regarded as a speculative or “junk” bond. So, as a bondholder, you should always hunt for investment-grade bonds.

Tesla, for example, is currently at a double B grade. That puts it in the realm of speculative bond investments. The yield is another factor when evaluating bonds. The yield indicates how much profit you are generating on a particular dollar amount invested. If you put one hundred dollars in bonds with a five percent yield, you may expect to receive five dollars of profit a year. Naturally, a larger return is preferable.

Are you one of those investors seeking for greater return on investment?

Well, then listen to this. In bonds, bigger returns also carry higher dangers. A twenty percent yield is undoubtedly superior to five percent, but any bond providing a twenty percent yield should be viewed with great caution. Why should you be cautious?

Okay, so let’s use Turkey’s government bonds as an example. It is currently predicted to have a 21.59 percent yield. If compared to U.S. treasuries, which are yielding at three percent, Turkey can attract a lot of bond investors. But, it has a credit rating of B plus, which belongs to the non-investment grade.

This means that Turkey’s government bonds have a higher chance of default. While U.S. treasuries do not have a high yield, it has never defaulted on any of their obligations. Even if the return on Turkish bonds is quite attractive, there is a chance that you won’t get your money back. This means that a greater yield does not guarantee credit quality. Lower creditworthiness is associated with higher yields and vice-versa.

A 21 percent yield sounds too good to be true. So, the closer a borrower is to a junk bond rating, the more cautious you need to be. When you have decided to buy bonds, you can purchase either a bond fund or an individual bond. A bond fund is created when different bonds are bundled together. Sort of like index funds with stocks.

These include hundreds or even thousands of bonds. And the great part is you can easily buy everything at once. And the diversity offered by bond funds is a plus. Your credit risk is distributed among the many borrowers when you use a bond fund. To do this, you must have an investing account or brokerage account. The most effective locations to accomplish this are at Fidelity, Schwab, or Vanguard.

Consider the Bond Exchange-Traded Fund ( or “ETF”) LQD. LQD holds more than two thousand different bonds. It is a widely diversified bond fund that distributes its credit risk over a wide range of borrowers. If one of those two thousand bonds fails to live up, it will not have a significant impact on your investment. It is safety in numbers.

Compared to purchasing individual bonds, bond ETFs or bond funds make it easier to invest. I published articles all about ETFs, Index Funds, and mutual funds which you can check out on our homepage.

It makes more sense to stick with investing in bond funds than picking out individual bonds because of the investment minimums requirement. These generally start at one thousand dollars. You also need to pay some fees and commissions when using a brokerage firm. While researching various bond funds or even individual bonds, you will encounter government bonds and corporate bonds.

Are you one of those investors seeking for greater return on investment?
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Government bonds vs Corporate bonds

Government bonds are obligations issued by the federal, state, or local governments. One particularly well-known example is the U.S. treasuries. IEF is a bond exchange-traded fund that invests in US treasuries. By comparison, LQD that I mentioned a moment ago focuses on corporate bonds. Since corporations are more susceptible to bankruptcy than governments, the yield on corporate bonds is greater than the yield on government bonds.

For instance, the yield on the US government bond fund, IEF, is now about 0.59 percent. But the corporate bond exchange-traded fund, LQD, has a much higher yield at 2.25 percent. So government bonds have lower yields than corporate bonds. A while ago, I mentioned that credit quality and yield are indirectly related. If the yield has a greater percentage, its credit rating might default. It is better to stick with government bonds if you are unsure of your bond investments.

Bottomline

That was a lot! Great job on making it this far. Just remember that a bond is a LOAN that you give to a borrower in exchange for interest. It is bound by a legal contract between the lender and the borrower. It is thought that Bonds are safer than stocks because you are guaranteed legally to receive at least your interest and your principal as long as the borrower doesn’t go bankrupt.

When choosing which bond to invest in, consider not just their yields but also their creditworthiness. Credit ratings can be used to determine creditworthiness. A triple-A rating has the safest while C ratings are the riskiest. You should carefully balance bond yield with creditworthiness because the riskiest, least creditworthy bonds typically pay the HIGHEST yields.

And if you’re a beginner, choose bond funds since it is convenient, cost-effective, and diverse. Through bonds, you can diversify your investment portfolio. So, as you can see, you might not want to have bonds be the majority of your investment portfolio. But they can definitely be a great strategic tool to use alongside your other assets. Are you a fan of bonds? Do you use them heavily in your investment plan? Share your thoughts in the comments below!

Disclaimer: The views presented in this article are only for informative and educational reasons. The article is not meant to give expert advice or suggestions for a specific security or product.

Also Read:

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