If you're looking for more predictable ways to invest, bonds might fit your investor profile. Find out more about what bonds are and how they work.
6 min read
If you're interested in investing, you've probably heard the term "bonds," maybe even in the same breath as other types of investments. But how do they work? And how are they different from stocks? You're not alone in wondering what bonds are — there are few important things to learn.Understanding bonds is crucial whether you're a beginner investor or just looking to expand your financial knowledge. In this article, we'll dive into the nitty-gritty of what bonds are, the risks of investing in them, and how they fit into the broader financial landscape.
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First things first: Governments or companies sometimes need additional cash flow. So, what do they do when they need an influx of cash? They issue bonds — as if they’re saying, "Hey, I need some money. Can someone lend me a hand?" And you, the bond investor, can be that helping hand. When you buy a bond, you're basically loaning money to the issuer. They promise to repay you the total loan amount (called the face value) on a specific date. Plus, bond issuers usually add interest payments along the way (a little bonus for being a good friend).Unlike stocks, where you can be part-owner of a company and reap the benefits of its success, bonds don't give you that privilege. While stocks fluctuate according to the market's value and company performance, bonds are considered a more predictable part of your investment portfolio. That’s because the company or government that issued the bond is meant to eventually repay it at full face value, and the schedule of interest payments is usually laid out from the beginning. However, there’s a little more to it than that — keep reading to learn how it all works.
How do bonds work?
Bonds are essentially loans. When governments or corporations need to raise money, they issue bonds. Investors purchase these bonds, essentially lending money to the issuer.Each bond has specific terms, including:
Face value: the amount the bond is for
Coupon rate: the interest rate
Maturity date: the date when the loan has to be repaid
Payment frequency: how often the bond earns interest
The issuer pays periodic interest payments to bondholders based on the coupon rate and face value. For instance, if you have a €1,000 bond with a 5% coupon rate, you'd receive €50 each year.At the bond's maturity date, the issuer repays the face value to the bondholder. This means you get back the original amount you lent, assuming the issuer doesn't default.Bonds can be bought and sold on the secondary market before they mature. The prices fluctuate based on factors like changes in interest rates, issuer creditworthiness, and market demand.Overall, bonds provide a way for investors to earn fixed income while lending money to governments or corporations, with the promise of repayment with interest later. It's a fundamental tool for both investors and issuers in the world of finance.
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Bonds can be issued by various entities, including:
Governments: National, state, and local governments issue bonds to fund various projects and operations. These are often called government bonds or sovereign bonds.
Corporations: Companies issue bonds to raise capital for expansion, acquisitions, or other financial needs. These are typically referred to as corporate bonds.
Municipalities: Local governments, such as cities, towns, or counties, issue municipal bonds to finance infrastructure projects like schools, roads, or utilities.
Government-Sponsored Enterprises (GSEs): Entities like Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) in the U.S. issue bonds to support specific sectors of the economy, such as housing finance.
Supranational organizations: Institutions like the World Bank or International Monetary Fund (IMF) issue bonds to fund projects and initiatives that promote economic development globally.
These entities issue bonds with varying terms, yields, and credit ratings, providing investors diverse investment options to suit their preferences and risk tolerance.
Investing in bonds
There are many ways to invest in bonds. You can purchase bonds directly from issuers, such as governments or corporations, either during initial offerings or on the secondary market, i.e. through brokerage firms or online platforms. Alternatively, investors can opt for bond funds, including mutual funds and ETFs, which provide diversified exposure to various bond types and issuers. So, why bother with bonds? They can boost your investment portfolio with a steady income stream (thanks, interest payments!) and help cushion the ups and downs you might experience while navigating the stock market.Before investing anywhere, though, individuals should consider their investment goals, risk tolerance, time horizon, and factors such as fees, expenses, and tax implications associated with bond investing. It ’s also wise to get personalized advice from a financial advisor. Now, let's look at some of the risks.
Risks of bond investing
Although they’re generally considered less volatile than stocks, bond investment does carry certain risks. If the issuing company or government collapses or ends up in financial difficulty, it might not have the cash to repay its debts. That’s just the most dramatic scenario — even poor company performance can drag down a bond’s price.Here are some more common risks associated with investing in bonds:
Interest rate risk: Bond prices typically move inversely to interest rates. When interest rates rise, bond prices fall, and vice versa. This can affect the value of your bond investments, especially if you need to sell before maturity.
Credit risk: The value of a bond is connected to the creditworthiness of its issuer, and some bonds are rated more highly than others. Corporations with lower credit ratings or governments facing financial instability are considered higher-risk issuers, for example. There’s a greater chance that they could default on the bond or that their creditworthiness could drive down the bond’s price — which means capital loss for the bondholder. Higher-risk issuers may offer higher coupon rates to compensate for the added risk.
Inflation risk: Bonds provide fixed interest payments, which can be eroded by inflation over time. If inflation rises unexpectedly, the purchasing power of the bond's future interest payments and principal repayment may decrease.
Liquidity risk: Some bonds may have limited liquidity, meaning there may not be many buyers or sellers in the market. This can make it challenging to sell your bonds at a fair price, especially in times of market stress.
For beginner investors, Guido Lonetti, Head of Product Investments at N26, recommends understanding your risk profile. “Investing always comes with risks. Usually, better returns come with higher risks. When you know your risk aversion, you can start building a diversified portfolio based on your risk profile,” he explains. This way, you can take your first steps with safety and confidence according to your own goals, budget, and risk profile.
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Disclaimer
These statements do not constitute investment advice relating to any financial instrument. Financial instruments can be subject to high fluctuations in value. A decline in value or a complete loss of the money invested is possible at any time.
FAQs
Bonds and loans involve borrowing and repaying money with interest, but they operate differently. Loans are direct agreements between a borrower and a lender, where the lender provides funds to the borrower, who agrees to repay the loan amount plus interest over a specified period. In contrast, bonds are debt securities that governments, municipalities, or corporations use to raise capital from multiple investors. Bond issuers agree to pay back the bond's face value at maturity and make periodic interest payments to bondholders until then. Bonds are often bought and sold on the secondary market among investors, whereas loans involve a direct relationship between the borrower and lender.
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