Investing in bonds explained
When it comes to investing your money, you have several options to consider, from stocks and shares to savings accounts or pensions. You can choose what works for you based on your needs and future plans.
One popular investment option for your money is investing in bonds or deposits. It is a simple, easy to understand, and safer investment option, if that’s what you’re searching for. You’ll find more information about what is a bond, how to invest in bonds, and types of bonds on this page.
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What are bonds?
Bonds can be described as IOUs. When you invest in bonds, you are essentially lending money to an institution, like the government or a company, and they are obligated to repay you with interest.
Typically, bonds involve two types of payments. The first is a lump sum payment made when the bonds reach their maturity date. The second type is a series of smaller payments, known as coupons, which are a fixed percentage of the lump sum amount.
Bond terminology explained
If you’re new to investing, it may seem daunting to explore new ways or types of investments. Luckily, bonds are fairly easy to understand in comparison to other, more complex investments. Here are some basic terms you need to know to understand what is a bond.
Issuer: The institution or company borrowing the money and issuing the bond is known as the issuer. For example, an institution can borrow €10,000 from you in exchange for 10,000 bonds.
Coupon: The issuer commits to paying an agreed upon rate of interest per year, known as a coupon. This is usually a fixed rate, which means you can calculate the interest you will earn before committing to buying bonds. For instance, if the coupon rate is 5%, and you invest €1,000 in bonds, you would receive €50 in annual interest.
Secured/Unsecured: Bonds can be secured or unsecured. A secured bond pledges available assets to you in case the borrower institution collapses. An unsecured bond is high risk, since you might receive very little or nothing in the event of a collapse.
Maturity: This is a date set for when the bond ‘matures,’ and therefore should be fully paid off by the issuer. For instance, if you invest in a 10-year bond in 2023, it will mature in 2033.
Par: Depending on how your bond trades on the stock exchange, it will either be above par, on par, or below par. For example, if you invested €1,500 into bonds, and they are trading at €2,000, they are above par. If they are trading for €900, they are below par, and so on.
Types of Bonds
The type of bonds you choose depends on who is offering them. In Ireland, two of the most commonly known types of bonds are Irish government bonds and corporate bonds.
Corporate bonds are issued by companies to raise capital. When you invest in a corporate bond, you are essentially lending money to the company. In return, the company agrees to pay you regular interest payments, aka coupons, over a specific period until the bond matures. At maturity, the company repays the initial amount borrowed, the principal, to the bondholder. There are multiple ways to check whether it’s a good corporate bond. You can check the credit rating of the bond (check the section on “how risky are bonds?”) and you can weigh the coupon against cash flows, whether the bond can easily be sold for ready cash.
Government bonds are issued by national governments to raise funds for various purposes. They offer fixed or variable interest rates, coupons, and have a specified maturity date when the government repays the borrowed amount to bondholders. These bonds are considered safe investments due to the government’s creditworthiness and are often used as a safe haven during market uncertainties.
How are bonds different from stocks or shares?
Stocks or shares offer a stake in the company, while a bond is a loan by the issuer or borrower for a fixed period of time at a fixed rate of interest. At maturity, the borrower that issued the bond will repay you your dues, effectively ending any relationship. But, as a shareholder, you continue to own a share in the company.
How does investing in bonds work?
Investing in bonds is similar to taking out a loan. For example, with government bonds, you are effectively lending money to the government. If you purchase €10,000 worth of bonds, you give money to the government, which they can use for various expenses such as infrastructure or other projects.
Let’s have a look at how investing in bonds work.
Let’s say you buy one bond for €100 on 1st August 2023. The interest rate is 1%, which you, as the bondholder, would receive every year as a coupon. This is a seven-year bond, reaching maturity on 1st August 2030.
Therefore, your calculations will look something like this: 1% * 100 = €1
This means you’ll be paid €1 each year as a coupon, earning a total of €7 in coupons by the time your bond matures.
Bond yield explained
Put simply, bond yield is the rate of return you receive on that bond.
Current Yield = Annual coupon Payment ÷ Bond Price
When investing in bonds in Ireland, the yield is influenced by your purchase price relative to the bond’s face value. If you invest in bonds at par, matching their face value, the yield is the same as the bond’s coupon rate. But, purchasing bonds below par leads to a higher yield than the original coupon rate, while buying above par results in a lower yield.
For instance, no matter what you pay for the bond value, you’ll earn the same coupon amount, while the yield rates change accordingly. As shown above, you can calculate it by dividing the annual coupon by the bond’s price and then multiplying by 100.
What are bond yields determined by?
Bond yields are mainly influenced by the base interest rate set by the European Central Bank (ECB). In times of low interest rates, bond yields are also low.
How risky are bonds?
Investing in bonds, especially in Ireland, come with some risks that you must be aware of before investing your money. Some of these risks are:
Inflation Risk: The risk that inflation could outpace the fixed income provided by a bond, resulting in a loss of purchasing power over time.
Time Risk: Bond investments lock your funds for the bond’s duration, limiting access until maturity.
Interest Rate Risk: Rising interest rates can lead to falling bond prices, causing value reduction. Interest rate fluctuations significantly impact bond markets.
Financial Risk: Credit risk, or business risk, which is the possibility that issuers will default on debt, is greater for unsecured bonds.
Selling Risk: Liquidity risk arises when you want to sell a bond but struggle to find a buyer.
When considering bond investments, it’s important to assess your risk tolerance. However, bonds generally offer more stability than stocks, because there is less fluctuation in bond value.
Examining a company’s credit rating or the bond’s rating can help you evaluate the risk associated with bonds.
|AAA||Investment Grade||Highest quality - lowest likelihood of default|
|AA||Investment Grade||High quality - very low likelihood of default|
|A||Investment Grade||Strong - low likelihood of default|
|BBB||Investment Grade||Medium grade - medium likelihood of default|
|BB,B||High Yield||Speculative - high risk of default|
|CCC,CC,C||High Yield||Highly speculative - high risk of default|
|D||High Yield||Default - unable to pay back debt|
How do investors compare bonds?
Comparing bonds comes down to what you like and how much risk you’re comfortable with. If you want higher returns, focus on bonds with higher interest rates and figure out how much you’ll earn by the time the bond matures. Your choice depends on your risk appetite and how much you’re willing to invest.
How to invest in bonds
If you’re planning to invest in government bonds in Ireland, you can find all the information you need on how to invest in bonds on the government website. As per the Central Bank of Ireland, only a regulated stockbroker can buy or sell Irish government bonds.
Corporate bonds are usually available on the secondary market through stockbrokers. However, determining a fair price for corporate bonds can be challenging due to this setup.
Pros and Cons of investing in bonds
Any experienced investor will tell you that you need to diversify your portfolio in order to mitigate risk. Bonds can be a great option for offsetting the risk of some of your other investments.
The return on bonds is often small, especially on those with lower risk.
Due to the high likelihood that you’ll recover all of your capital, particularly if you buy gilts, investing in bonds is typically a safe option for investing.
Interest rate risk
As with most investments, the value of a bond will depend largely on the current interest rate.
The benefit of receiving a coupon either annually or bi-annually is that you’ll enjoy regular income from your bonds.
Your money is locked away
When you buy a bond, you are agreeing to lock your money away and will only recover it fully on your bond’s maturity date.
Bond market transparency
As most bonds are sold on a second market, brokers can sometimes charge more than the bond is worth to make a profit.
Lower earnings than stocks
While they offer less risk, bonds don’t typically earn you as much money as investing in stocks and shares.
7 things to consider when investing in bonds
When considering bonds in Ireland, there are important steps to follow:
- Before investing, check the bond’s maturity date and ensure you won’t need your money during that period.
- If you’re using a bond broker, ensure they’re regulated by the Central Bank of Ireland and inquire about their fees.
- Aim for a bond with a credit rating of C and above; lower ratings pose higher default risks.
- Research companies thoroughly, particularly their cash flow, before investing in corporate bonds. Ethical considerations might lead you to explore the company’s investments.
- Understand your risk tolerance; avoid impulsive decisions based solely on high predicted yields.
- Diversify your investments across your portfolio for balanced risk.
- Carefully read the terms and conditions, being aware of potential costs.