What are bonds and how to make money on them

Bonds are a suitable instrument for novice investors. Let’s talk about the types of bonds, how to assess their returns, their advantages, and the risks to keep in mind.

Bonds are essentially IOUs issued by companies or governments to raise funds. When individuals purchase bonds, they are lending money to the issuer and expect to receive a specified return on their investment. This return is usually in the form of periodic interest payments and the repayment of the principal amount at maturity.

While some bonds have a fixed maturity date, there are also perpetual bonds that have no specific maturity but provide regular interest payments. However, the issuer may have the option to redeem them at certain intervals.

Bonds can be issued by governments, corporations, or financial institutions, and they vary in complexity. Some bonds are straightforward, where the issuer promises to pay back the principal and interest according to a predetermined schedule. Others, like structured bonds, are more complex and involve investment strategies beyond the performance of a single company.

Investing in bonds carries risks. The main risk is the potential default of the issuer, which could result in the loss of the invested funds. Unlike bank deposits, bonds are not usually protected by deposit insurance. Therefore, it’s important for investors to carefully consider the creditworthiness of the issuer before investing in bonds.

Overall, bonds can be an attractive investment option for those seeking regular income and relative stability. However, it’s crucial to assess the credit risk associated with the issuer and understand the terms and conditions of the bond before making any investment decisions.

What are the types of bonds?

There are several types of bonds distinguished by various parameters.

Based on the issuer:

1. Government Bonds: These are issued by countries or regions to cover budget deficits.
2. Municipal Bonds: These are issued by local government bodies to finance various projects.
3. Corporate Bonds: These are issued by companies to raise capital for their development and operations.
4. Investment-grade and Structured Bonds: These are issued by banks, brokers, and asset management companies to invest investors’ money in other securities and earn a commission.

Private companies can also issue a special type of bond called commercial bonds, which are distributed selectively through closed subscriptions. They are not available for purchase on the open market exchanges.

According to the form of payment of income:

There are different types of bonds based on the form of income payment:

1. Coupon Bonds: These bonds pay interest, also known as a coupon, on the nominal value of the bond. Some bonds have a single payment, while others have multiple payments. In the past, paper bonds had attached coupons that were detached upon payment.

1. • Fixed-Rate Coupons: These bonds have a constant interest rate throughout the bond’s life.
   • Fixed-Rate Step-Up Coupons: The interest rate for each payment period is predetermined but can change over time.
   • Variable-Rate Coupons: Long-term bonds may have a fixed rate until a specific point, after which the issuer can adjust the interest rate based on market conditions.
   • Floating-Rate Coupons: The interest payments on these bonds are linked to macroeconomic indicators such as inflation rates or the central bank’s key rate.
2. Discount Bonds: These bonds are purchased below their nominal value but are redeemed at the full nominal value upon maturity.
3. Index-Linked Bonds: These bonds have a fixed coupon rate, such as 2.5% of the nominal value, but the nominal value itself is regularly adjusted, often based on inflation rates. Some government bonds traded on the exchange have index-linked nominal values that reflect changes in the country’s price levels.
4. Structured Income Bonds (Investment Bonds): The income on these bonds is not fixed or guaranteed. The payout is determined by pre-defined conditions. For example, if the price of oil or a stock market index falls within a predetermined range for a certain period, the coupon income may be 20%. If it exceeds the range, the income may be reduced to 10%, or no coupon may be paid. However, the nominal value of the bond will be returned regardless of market conditions.
5. Structured Bonds: These bonds often have more complex payout conditions than structured income bonds. In some cases, you may receive less money than you invested in the bond. For example, the payout may depend on the performance of shares in four different companies. If the prices of all four stocks increase by more than 10% during the bond’s term, the coupon will be 20%. If at least one stock increases less than 10%, you will receive a coupon of 12%. If two or more stocks decrease in value, you may only receive 80% of the nominal value upon redemption.

By maturity:

Based on the maturity period, bonds can be categorized as follows:

1. Short-term Bonds: These bonds have a maturity period of less than one year.
2. Medium-term Bonds: Bonds with a maturity period ranging from 1 year to 5 years.
3. Long-term Bonds: Bonds with a maturity period exceeding 5 years.
4. Perpetual Bonds: These bonds do not have a fixed maturity date and are sometimes referred to as “eternal” or “unending” bonds. The issuer does not have an obligation to repay the principal amount, but they may provide periodic interest payments indefinitely.

It’s important to note that the specific categorization of bonds based on maturity can vary across different financial markets and countries. The above classification provides a general understanding of the terms commonly used to describe bond maturities.

By security:

In terms of security, bonds can be categorized as follows:

1. Secured Bonds: These are the most reliable bonds, offering a high level of security for bondholders. The investment is safeguarded by collateral, such as company real estate, equipment, or other securities. In the event of the issuer’s bankruptcy, the bondholder can claim and sell the collateral to recover their investment. Another form of security is when another company guarantees the bonds. If the issuer goes bankrupt, the guaranteeing company assumes the obligations of the bonds. A third form of security is provided through bank, government, or municipal guarantees. In such cases, the debts of the bonds are backed by a bank or the local/federal budget.
2. Unsecured Bonds: These bonds are less secure compared to secured bonds. If the issuing company goes bankrupt, bondholders have to wait until the bankruptcy process is completed and their claims are satisfied along with other creditors. There is no guarantee that they will recover their entire investment.
3. Subordinated Unsecured Bonds: These are the riskiest bonds. In the event of the issuer’s bankruptcy, investors can expect to receive repayment only after all other creditors have been paid. In many cases, there may be little to nothing left to distribute among subordinated bondholders. If a bank issues subordinated unsecured bonds and faces financial problems leading to regulatory intervention, the debt related to these securities may be written off.

Please note that this information is a simplified explanation and may not cover all aspects of bond security.

By circulation method:

In terms of tradability, bonds can be classified as follows:

1. Freely Tradable Bonds: There are no restrictions on the purchase and sale of these bonds. They can be freely bought and sold, allowing ownership to be transferred from one investor to another without any limitations.
2. Restricted Tradable Bonds: The purchase and sale of these bonds are subject to certain restrictions. For example, the bondholder may be prohibited from selling the bonds for a certain period of time. Alternatively, the issuer may impose restrictions on the bond price, setting limits on how much the bond can be sold for, either above or below a specified limit.

What risks can a bondholder face?

What risks can bondholders face? Investing always involves risk, and when purchasing bonds, it is important to consider the following:

Default risk – the risk that the issuer will go bankrupt and be unable to fulfill its financial obligations to the investor. If you hold secured bonds, this risk is relatively low as you can potentially recover your investment through collateral, guarantees, or surety.

Debt restructuring risk – the risk that the issuer will modify the repayment terms, coupon payments, or other conditions of the bonds. The company may propose new terms to investors if it realizes that it cannot meet its initial promises.

Liquidity risk – the risk that you may not be able to sell your bonds quickly at a fair price if you wish to do so before maturity. There may be few or no buyers for your securities, especially if the issuer faces financial difficulties or is relatively unknown. It is also typically challenging to find buyers for structured bonds and bonds with structured income.

Interest rate risk – the risk that market interest rates for similar bonds will rise. If your bonds have a fixed interest rate that is lower than the prevailing market rate, your returns would be lower compared to other investors who purchase bonds with the new terms. If you want to sell your bonds prematurely, you may have to reduce the price below the face value to attract another investor.

This risk is closely related to changes in the key interest rate set by the central bank, which affects other interest rates in the financial market. When the key rate decreases, interest rate risk is mitigated. However, when it increases, the yield on new bonds usually rises, increasing the interest rate risk for holders of existing bonds.

Inflation risk – the risk that inflation accelerates and erodes the bond’s yield. This means that your real capital may not grow, and you may lose a portion of its value. In other words, the purchasing power of your future income from the bond may decrease.

Investors should always be prepared for potential loss of capital, but for structured bonds, the risk of losses can be highlighted separately since it is known in advance that under certain conditions, the repayment amount will be below the face value.

How to minimize all risks?

To minimize risks, it’s important to keep in mind that lower risks generally correspond to lower returns. This is a market law.

The most reliable bonds are typically government bonds, such as Federal Loan Bonds (OFZ) issued by the Ministry of Finance. Their yield is usually low but still higher than inflation.

Before purchasing bonds, it’s crucial to check the financial standing of the issuing company. Stay updated on news and examine publicly available financial and accounting reports, which can be found on exchange websites and authorized information agencies. It’s advisable to monitor the issuer’s status even after purchasing the securities.

Carefully read the terms and conditions of the bond issuance. Determine the frequency and method of payments and where all the important information about the securities will be published. Find out if the issuer has the right to redeem or call the bonds before maturity, and whether bondholders have the ability to demand early redemption. If you’re considering investing in foreign bonds, evaluate the risk of their being blocked.

Overall, conducting thorough research, diversifying your portfolio, and being aware of the specific risks associated with each type of bond can help minimize risks in bond investments.

Pros and cons of bonds

Advantages:

1. Predictable income: Bonds offer a fixed income, which means investors know how much they will earn from their investment. This is especially beneficial for those seeking stability and regular cash flow.
2. Lower risk compared to other investments: Bonds are generally considered less risky than stocks and other securities. This is because bondholders have priority in receiving payments from the issuer, and in the case of default, they have a higher chance of recovering their investment.
3. Preservation of capital: Bonds are often seen as a safer investment option since they provide the return of the principal amount upon maturity. This makes them appealing for investors who prioritize capital preservation over higher returns.
4. Diversification: Bonds can be used to diversify an investment portfolio. By including bonds from different issuers, industries, and regions, investors can reduce their overall risk exposure and potentially offset losses from other investments.

Disadvantages:

1. Lower potential returns: While bonds offer stability, their returns are typically lower compared to riskier investments such as stocks. This means that investors may miss out on higher profit opportunities in exchange for more predictable income.
2. Lack of deposit insurance: Unlike bank deposits, bonds are not covered by deposit insurance. If the issuer defaults or goes bankrupt, investors may lose their investment partially or entirely.
3. Interest rate risk: Bond prices are influenced by changes in interest rates. When interest rates rise, bond prices tend to fall, which can lead to capital losses for investors who wish to sell their bonds before maturity.
4. Inflation risk: Bonds are exposed to inflation risk, which refers to the potential loss of purchasing power due to rising prices over time. Fixed interest payments may not keep pace with inflation, resulting in a decrease in the real value o f the investment.

It’s important for investors to carefully consider these pros and cons before investing in bonds and to assess their risk tolerance, investment goals, and time horizon.