How to Invest in Bonds for Beginners

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If you’re looking for an investment that’s less risky than the stock market but earns higher than time deposits, then consider investing in bonds.

But what are bonds? How do you make money from them? What are the risks? And finally, how do you invest in bonds?

What are bonds?

A bond is a debt security. As a debt, it means there’s someone who is borrowing money and there’s another one lending it. As a security, it means the borrower is under a legal obligation to pay the lender.

The borrower is referred to as the bond issuer. Meanwhile, the lender is the bondholder. In most cases,  there are two basic types of bonds: government bonds and corporate bonds.

Government bonds are also called retail treasury bonds, treasury notes, T-Bills, and many others. When you invest in government bonds, it means that you are lending money to the government.

On the other hand, corporate bonds are sometimes called long-term commercial papers. When you invest in corporate bonds, it means that you are lending money to a corporation.

 

How do you make money from investing in bonds?

You are lending money, so naturally, you will earn from the interest payments. When it comes to bonds, there are three terms that you must understand:

  1. Par value– the face value of the bond or simply, the amount of money you’re lending to the borrower (or the amount you are investing).
  2. Coupon rate– the interest or the amount of money that the bond issuer will pay the bondholder periodically (or the amount you will earn every year).
  3. Maturity date– the date when the bond issuer returns the par value to the bondholder (or the date when you get back the money you invested).

Let’s say a corporate entity needs $1 billion to fund several real estate projects. To raise that amount of money, they decided to sell corporate bonds to the public with a coupon rate of 8% per annum and a maturity date of 10 years.

If you invest $100,000 on this bond, then you will earn a total of $80,000 from this investment before taxes.

8% per annum of $100,000 is $8,000 per year. Since the maturity date is 10 years, then you will receive $8,000 (less 20% withholding tax or whatever tax applicable ) every year for the next 10 years. At year 10, the cooperation will then return the $100,000 principal to you.

It’s important to note that some bonds pay quarterly or semi-annually. If so, then you just divide the annual rate accordingly.

In our example, if the company wants to pay the coupon rate every six months, then you’ll receive $4,000 (or $3,200 after taxes) twice a year for the next ten years.

Furthermore, there are zero-coupon bonds that are sold at a price lower than the face value. However, you won’t receive regular interest payments.

What are the risks of investing in bonds?

There are a lot of risks when investing in bonds, but you don’t lose money in most of them.

In our example above, the Company could decide to “pre-terminate” the bond. That instead of 10 years, they can pay back the principal after 5 years.

Or it can decide to decrease the coupon rate to 6% per annum. When this happens, bondholders will be given the option to redeem the par value if they don’t want to continue with the new rate.

When the country’s inflation rate goes higher than the bond’s coupon rate, then your money will lose some value. Because it’s frozen until the maturity date, you can’t take and reinvest your money in better opportunities.

The worst-case scenario and the only time you could lose money is if the company goes bankrupt. When this happens, you can still get back a portion of your investment after the company’s assets are liquidated.

The same risks exist for government bonds but are less likely to happen because the Central Bank can just print more money or the government can increase taxes to pay bond obligations.

This is the reason why retail treasury bonds are more popular than corporate bonds, as they have almost zero risks.

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