Almost every person has at least once borrowed some money from somebody else. This can even be a few cents. Some people might say that this is a part of their life. This is also done by a lot of companies. Even the municipalities and federal government do so. Anyone connected with any organisations can borrow some money by issuing bonds.
Let’s have a look at how does the bond market work and what’s it all about.
What are bonds?
Bonds are loans that are made by an investor who is also called a bondholder to a borrower (issuer) and brings an income that was discussed ahead to the person or organisation that gives the money. This is done by various organisations and companies for financing different projects and similar stuff.
The bond owners are called debtholders, creditors or issuers. The last word is used more commonly. There is some official documentation to be made after discussing the bond details. There should be indicated the end date or the deadline at which the borrower should pay the bond owner the full sum. The end sum also often includes the terms for variable or fixed interest payments that are made by the loaner. This way, the bondholder gets a profit.
So, it’s simple. An entity issues a bond asking for some money to be invested and makes a deal to return the full sum and interest in a certain period of time. You can often meet organisations that take a higher interest rate if the deadline is moved.
As any other thing, bonds have their own characteristics. There are five main details that should be known. These include:
一 is the price the bond will cost when it matures. It also is the amount of money that is used by the bond issuer when calculating interest payments. Imagine that an investor buys a bond for $1090 and another investor purchases the copy of the same bond in another time when it is traded for $980. When it matures, both will receive $1000 dollars.This is the face value with all calculations of this specific bond.
一 is the rate of interest that is paid by the issuer on the face value of the bond. This criteria is mostly calculated as a percentage. If the coupon rate is 5%, than the bondholder will earn this percent from the face value. If it is $1000, then every year a profit of $50 will be received.
一 are the dates when the bond issuer should make interest payments. They can be made in any discussed interval at which both sides agree. Mostly semiannual payments are used.
一 is the date when the bond matures. This is when the issuer is supposed to pay the bondholder the bond’s complete face value.
一 is the price the bond issuer usually sells bonds.
Bonds also have such a feature as credit quality. For example, when an issuer has a poor credit rating, a higher interest rate it pade. The reason is that the chance of default is higher than usual.
Credit ratings are calculated by special agencies. Highest quality bonds are called “investment grades”. These mostly include debts that are issued by the US government or really stable companies. All other bonds that aren’t in default are called “high yields” or “junk”. A higher coupon payment is demanded when working with these as investors need a compensation of their risks in any way.
Also, if the bond has a long maturity date, more interest is paid as well. This is done because the bondholder has to be exposed to a higher inflation risk and the additional sum is something like a compensation.
“Duration” is another characteristic that isn’t connected to time. Beginners might be confused, so it’s important to set this clear at once. “Duration” represents bonds and their portfolios sensitivity to various changes in the interest rate.
“Convexity” is one more term that needs to be known. It is used to show the change rate of a bond or portfolio to “duration”. Convexity hard to calculate, so mostly this job is left for professionals.
How to earn money on bonds?
The way the bond market works is simple when you start understanding the basics. Bonds investment has two ways of bringing profit.
At first, an investor should hold bonds and wait for their maturity date to receive interest payment. As it was already mentioned, the interest payment interval differs in every deal, but the most common choice is twice a year.
Then goes bond trading. The main idea is to sell your bond for a higher price to gain enough profit. Imagine you own a $10000 bond and sell it for $11000 at the moment it’s market value increases. This way you get $1000 of clean income. Everything depends on the moment and your luck.
What types of bonds are there?
There are three basic types of bonds. Every has its own advantages and drawbacks.
一 these are issued by corporations. They are needed to raise capital for various operations that are related with business: research, company expansion, product investment etc. Such bonds are good for their high interest rates and are bad a cause of their taxability by the state and federal government.
一 these are always issued by stater or cities and other localities and are used for financing different projects and public services. Imagine a situation where a city need to construct a bridge and needs money for that. That is when a municipal bond is issued. There are two different varieties of it: a general obligation and revenue. In the first case the issuer does all necessary operations to repay bondholders before the deadline. In the second case, the issuer uses the income that is received by the project created for the bondholders money to repay him. In any way, municipal bonds pay a lower interest in comparison with the corporate ones, but the profit is exempt from federal taxes. If a municipal bond is bought in the bondholders home state, he avoids state and local taxes too.
一 are only issued by the government. The interest received from this type of bond is taxable only at the federal level. The biggest drawback is that treasury bonds have a really big maturity period. It can be 10 years or longer. The advantage is that the government will do any necessary thing to repay all interest to the bondholder, so this is the reason treasury bonds are usually considered to be safe and risk-free. But these too, as municipal bonds, do not offer such a high interest rate that corporations do.
How are bonds bought
If you are in to stock trading, you should know that it isn’t complicated to buy or sell shares. Bonds are mostly bought from brokers. The only exception are treasury bonds that can be bought directly from the government.
This system isn’t always trusted as investors aren’t always sure that they are buying the bond for a fair price. One broker can sell a certain bond for a real price, while another one can sell this bond at a “premium” that is much higher than the actual price.
With Maxitrade you can be sure that you will always know the bonds real market prices. All deals are going to be made with an experienced broker with a lot of good reviews that can be trusted.
Additionally, the bond market is regulated by the Financial Industry Regulatory Authority or FINRA in short. This organisation posts online real transaction prices when they have the data, although investors say that there often are freezes in the system.
Bond investment: pros and cons
At first, let us discuss the advantages of investing money in to bonds. The primary benefit is that this type of investment is that it is mostly risk-free. Bond values do not tend to change as rapidly as share prices do, that is why there are less worries about them. Sometimes there is a chance to catch really good deals from top companies like Google, but you need to have enough funds to invest and time to monitor the market.
The next advantage is that bonds allow to calculate the precise profit ahead. If you have a deal to be paid every half a year, than you can definitely rely on that money. By working with municipal or treasury bonds you even make sure to be freed from tax paying.
The final pros is that when you invest into a municipal bond, you help to develop the community. For example, your money can be used to renovate a school, develop a park, build a hospital and other stuff that is really useful. This way you can personally help improving everything around you and earn money at the same time.
Now let’s get to the drawbacks of this type of investment. The biggest problem is that bonds require the bondholder to give away his money for a long period of time. If the bond term is 5 years, that you are supposed to keep that money invested for all the time until the deal is over. The stock market doesn’t work this way as you can always sell your share by one click as only you see that there is some profit to be made. Of course, bonds can also be sold, but there is a less chance that it’s going to be profitable. You will find cheaper offers more likely.
Even though we already called bonds almost risk-free, that part still exists. This is a long term investment, so imagine that you have made a deal with 3% interest payments every year for 10 years ahead. In one month after the deal is made you see that the same issuer already offers bonds at 4% interest. At this moment your bond drops in value and by holding it you lose an increased potential income getting stuck at the 3% interest rates.
You also shouldn’t forget that there always is a possibility that the issuer defaults on its obligations. This means that appears a risk of you, as the bondholder, to lose your interest payments. What’s even worse is that in this situation there is no guarantee that your principal will be repaid. But by doing some proper analysis you can predict the possibility of a default to happen.
Finally, bonds aren’t considered to be as profitable as stocks. There was a research that calculated that from 1928 till 2010 the average return for bonds was near 5.28% while stocks had an average of 11.3%. The payment is higher for bigger risks.
How do i know that bond trading is for me?
There are a few points you need to make sure of the see whether working with the bond market is good enough for you. Here we go:
- Your personal finance allows you to make a proper investment;
- you are interested in long-term investments;
- there a municipal issuers and you can and want to help the community;
- you want minimum risks;
- you can afford to be without the money invested till the end of the contract period.
If this suits you, then you can go straight to the bond market with Maxitrade’s help and choose the best offer for you.
What are you waiting for?
As a person interested in the financial world, you should know that time is money! That is why you shouldn’t lose it without gaining profit.
Create your personal account on Maxitrade and visit the bond market there to find the best offers that are available. You also might be interested in any type of trading that is offered by the broker as this might be an even more profitable investment.