How to invest in Bonds?
These days everyone prefers to invest in the stock market but investing in the stock market comes with many risks and uncertainties. Bonds, on the other hand, are a much a safer investment as investors not only receive their principal amount back but also receive an annual, fixed interest payment till the bonds expire. Sounds interesting, no? Before you start investing in bonds, it is important for you to understand some basic concepts.
Bonds are a debt investments that an investor (possibly you) lends to either the government or a private corporation. The government and private companies sometimes need extra finance for any future projects or to maintain their current expenses. One way through which they can increase funds is through issuing bonds. But what is in store for the investors? Let’s explain this through an example. Say there is a bond that has a face value of $1000 that is being sold for the same amount by the government. Face value is the money that an investor will receive when the bond matures. You decide to buy the bond and invest $1000 to the government. The bond has a maturity date of 5 years. So after 5 years, your bond will be of no value and the government will pay you back $1000. But to make this more attractive, the government will offer a coupon rate of 5%. Coupon rate is the interest rate that will decide how much interest payment you will receive. So by the end of 5 years you will not only receive $1000 but $250 total interest. Thus, by investing $1000 you will receive $1250 at the end of 5 years.
You may be attracted now to invest in bonds but you need to consider the possibility of a default risk. Default risk is when the borrowing entity refuses to pay back the principal amount invested by the lender. The default risk is more with entities that offer a higher coupon rate. Governments are considered less risky but offer lower coupon rates. In comparison, private companies offer higher coupon rates but the chances of default risks are more. In order to limit the risk associated with bonds, several credit ratings agencies assign ranks to different bonds, like AAA or BB+. These ranks are assigned on the basis of a certain criteria and show the financial strength of the bond issuer. It is always recommended to compare ranks but keep in mind that these ranks may not always be accurate.
Since now you know about what bonds are and which bonds to select, you can now invest in bonds. There are generally three ways through which you can buy bonds. The first is to use a full-service broker or a discount broker. Full-service brokers provide you with personal attention but are usually costly. Discount brokers are usually based online and are cheaper than full-service brokers but do not provide the same personal attention. You can open an account with your broker and they will carry out your bond transactions for you. However, you must be aware that some brokers may fool you and charge you more so you better do your research beforehand. The second way to buy bonds is through banks. Some financial institutions provide the facility of transacting government securities. The third way is to buy bonds directly from the government’s website. All of the transactions are done electronically. However, keep in mind that not all governments offer this facility.
This wraps up this tutorial. Now you are fully equipped with the basic knowledge, risk and different methods of investing in bonds.