What are Investment Bonds? Overview, and How they Work?

Want to strengthen your portfolio’s risk-return profile? Adding bonds can create a more balanced portfolio by adding diversification and calming volatility. But the bond market may seem unfamiliar even to the most experienced investors.

In this article, you will learn so many things about Investment Bonds and how they work.

What Is An Investment Bond?

An investment bond is a single-premium life insurance policy that can be used to hold investments in a tax-efficient manner.

As with any investment, the value of the bond may go up or down depending on how well your investments perform. The investor might not get back their initial investment.

You might consider an investment bond if you:

  • Have at least £5,000 that you wish to invest.
  • Can afford to invest your savings for a set amount of time.
  • Are comfortable with the potential risks and fluctuating value of your investment.

Are Investment Bonds a Good Idea?

Bonds are a defensive asset. They can provide a stable source of income and aim to protect the money you invest.

They are less risky than growth assets like shares and property and can help you diversify.

When you invest in bonds, you’re lending money to a company or government. In return, you get regular interest payments, called coupon payments. If you hold the bond until maturity, you get back the face value of the bond.

Reasons To Invest In Bonds

The main reasons people invest in bonds are:

Stable income Stream

Bonds pay interest (coupon payments) at regular intervals and can provide a stable and predictable income stream. The interest rate you can earn on a bond may be higher than a savings account or term deposit. Some bonds, especially government bonds, also have high liquidity, meaning they’re easy to sell if you need to free up money quickly.

Lower risk

Bonds are defensive investments and lower risk than growth investments like shares or property.

The amount of risk depends on the issuer of the bond: either the Australian Government (lowest risk) or a company (higher risk).

Diversify your portfolio

Bonds are often used to diversify a portfolio. Diversification lowers the risk in a portfolio because no matter what the economy does, some investments are likely to benefit. For example, when interest rates fall, bond prices rise, while shares often fall at this time.

Characteristics Of Bonds

A bond is simply a loan taken out by a company. Instead of going to a bank, the company gets the money from investors who buy its bonds.

In exchange for the capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value.

The company pays the interest at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan.

Unlike stocks, bonds can vary significantly based on the terms of their indenture, a legal document outlining the characteristics of the bond.

Because each bond issue is different, it is important to understand the precise terms before investing. In particular, there are six important features to look for when considering a bond.

Maturity

This is the date when the principal or par amount of the bond is paid to investors and the company’s bond obligation ends.

Therefore, it defines the lifetime of the bond. A bond’s maturity is one of the primary considerations an investor weighs against their investment goals and horizon. Maturity is often classified in three ways:

  • Short-term: Bonds that fall into this category tend to mature within one to three years
  • Medium-term: Maturity dates for these types of bonds are normally over ten years
  • Long-term: These bonds generally mature over longer periods of time
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Secured/Unsecured

A bond can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company cannot repay the obligation.

This asset is also called collateral on the loan. So if the bond issuer defaults, the asset is then transferred to the investor.

Mortgage-backed security (MBS) is one type of secured bond backed by titles to the homes of the borrowers.

Unsecured bonds, on the other hand, are not backed by any collateral. That means the interest and principal are only guaranteed by the issuing company. Also called debentures, these bonds return little of your investment if the company fails. As such, they are much riskier than secured bonds.

Liquidation Preference

When a firm goes bankrupt, it repays investors in a particular order as it liquidates.

After a firm sells off all its assets, it begins to pay out its investors. Senior debt is debt that must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.

Coupon

The coupon amount represents interest paid to bondholders, normally annually or semiannually.

The coupon is also called the coupon rate or nominal yield. To calculate the coupon rate, divide the annual payments by the face value of the bond.

Tax Status

While the majority of corporate bonds are taxable investments, some government and municipal bonds are tax-exempt, so income and capital gains are not subject to taxation.

Tax-exempt bonds normally have lower interest than equivalent taxable bonds. An investor must calculate the tax-equivalent yield to compare the return with that of taxable instruments.

Callability

Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par.

A company may choose to call its bonds if interest rates allow them to borrow at a better rate. Callable bonds also appeal to investors as they offer better coupon rates

How to Invest In Bonds

Buying bonds can prove a little trickier than buying stocks, because of the initial amount required to begin investing.

The face value of most bonds is $1,000, though there’s a way around that. You have a few options on where to buy them:

From a broker

You can buy bonds from an online broker. You’ll be buying from other investors looking to sell.

You may also be able to receive a discount off the bond’s face value by buying a bond directly from the underwriting investment bank in an initial bond offering.

Through an exchange-traded fund

An ETF typically buys bonds from many different companies, and some funds are focused on short-, medium-, and long-term bonds, or provide exposure to certain industries or markets. 

A fund is a great option for individual investors because it provides immediate diversification and you don’t have to buy in large increments.

Not all bond investments are created equal. Use this three-step process to evaluate whether various bonds fit your portfolio:

Can the borrower pay its bonds?

The answer to this question is paramount, because if a company can’t pay its bonds — its promise to pay back money lent, with interest — there’s no reason for the average investor to consider buying them.

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With some sleuthing, you can estimate whether the company is able to meet its debt obligations.

Bonds are rated by rating agencies, with three big ones dominating the industry: Moody’s, Standard & Poor’s and Fitch. They estimate creditworthiness, assigning credit ratings to companies and governments and the bonds they issue.

The higher the rating — AAA is the highest, and it goes down from there, like school grades — the greater the likelihood the company will honour its obligations and the lower the interest rates it will have to pay.

Is now the right time to buy bonds?

Once a bond’s interest rate is set and made available to investors, the bond trades in what’s called the debt market. Then the moves of prevailing interest rates dictate how the bond’s price fluctuates.

Bond prices tend to move countercyclically. As the economy heats up, interest rates rise, depressing bond prices. As the economy cools, interest rates fall, lifting bond prices.

You might think that bonds are a great buy during boom times (when prices are lowest) and a sell when the economy starts to recover. But it’s not that simple.

Investors try to predict whether rates will go higher or lower. But waiting to buy bonds can amount to trying to time the market, which is not considered a good idea.

To manage this uncertainty, many bond investors “ladder” their bond exposure. Investors buy numerous bonds that mature across a period of years.

As bonds mature, the principal is reinvested and the ladder grows. Laddering effectively diversifies interest-rate risk, though it may come at the cost of a lower yield.

Which bonds are right for my portfolio?

The type of bonds that might be right for you depend on several factors, including your risk tolerance, income requirements and tax situation.

A good bond allocation might include each type — corporate, federal and municipal bonds — which will help diversify the portfolio and reduce principal risk. Investors can also stagger the maturities to reduce interest-rate risk.

Diversifying a bond portfolio can be difficult because bonds typically are sold in $1,000 increments, so it can take a lot of cash to build a diversified portfolio.

Instead, it’s much easier to buy bond ETFs. These funds can provide diversified exposure to the bond types you want, and you can mix and match bond ETFs even if you can’t invest a large amount at once

How Do Investment Bonds Work?

Most of us are used to borrowing money in some capacity, whether it’s mortgaging our homes or bumming a few bucks off a friend.

Similarly, companies, municipalities, and the federal government borrow money, too. How? By issuing bonds.

Bonds are a way for an organization to raise money. Let’s say your town asks you for a certain investment of money.

In exchange, your town promises to pay you back that investment, plus interest, over a specified period of time.

For example, you might buy a 10-year, $10,000 bond paying 3% interest. Your town, in exchange, will promise to pay you interest on that $10,000 every six months, and then return your $10,000 after 10 years.

There are two ways to make money by investing in bonds.

The first is to hold those bonds until their maturity date and collect interest payments on them. Bond interest is usually paid twice a year.

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The second way to profit from bonds is to sell them at a price that’s higher than what you pay initially. For example, if you buy $10,000 worth of bonds at face value — meaning you paid $10,000 — then sell them for $11,000 when their market value increases, you can pocket the $1,000 difference.

Read more: 9 Best Fixed Rate Bonds In 2022 | Expert Guide

Bond prices can rise for two main reasons. If the borrower’s credit risk profile improves so that it’s more likely to be able to repay the bond at maturity, then the price of the bond typically rises. Also, if prevailing interest rates on newly issued bonds go down, then the value of an existing bond at a higher rate goes up.

Conclusion 

If you’re the risk-averse type who truly can’t bear the thought of losing money, bonds might be a more suitable investment for you than stocks.

If you’re heavily invested in stocks, bonds are a good way to diversify your portfolio and protect yourself from market volatility.

If you’re near retirement or already retired, you may not have the time to ride out stock market downturns, in which case bonds are a safer place for your money.

In fact, most people are advised to shift away from stocks and into bonds as they get older, and it’s not terrible advice, provided you don’t make the mistake of dumping your stocks completely in retirement.

Frequently Asked Questions

What are municipal bonds?

A municipal bond is a debt issued by a state or municipality to fund public works. Like other bonds, investors lend money to the issuer for a predetermined period of time. The issuer promises to pay the investor interest over the term of the bond (usually twice a year), and then return the principal back to the investor when the bond matures.

What are treasury bonds?

A Treasury bond is a debt issued by the U.S. government to raise money. Technically speaking, every kind of debt issued by the federal government is a bond, but the U.S. Treasury defines the Treasury bond as a 30-year note. Generally considered the safest investment in the world, U.S. Treasury securities of all lengths provide a nearly guaranteed source of income and hold their value in just about every economic environment.

What are corporate bonds?

A corporate bond is a debt instrument issued by a business to raise money. Unlike a stock offering, with which investors buy a stake in the company itself, a bond is a loan with a fixed term and an interest yield that investors will earn. When it matures or reaches the end of the term, the company repays the bondholder

What are the benefits of investing in bonds?

  • Safety
  • Income
  • Community
  • Diversification

Can you lose capital on bonds?

Bonds tend to pay a fixed interest rate although some returns are linked to a benchmark such as an index. … If the bond issuer can’t repay you, you can lose all of your capital.

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