A Beginner’s Guide to Investing in Bonds

If you’re interested in investing, then you will have almost certainly heard of bonds. Bonds are among the most common financial instruments and are a very popular topic in any investment course. The reason for this is quite simple — bonds offer many attractive opportunities for investors and are a very flexible investment option, making bonds a profitable addition to any investor’s portfolio, especially a beginner’s. If you want to learn how to invest in bonds and use them in your own portfolio, keep reading.

What are bonds?

A bond is a lending instrument. Buying a bond is equivalent to lending a certain sum of money to the issuer of the bond. In turn, the issuer periodically pays you a fixed sum of money (the interest effectively). Bonds typically have a fixed period of maturity. At the end of the period of maturity, the issuer of the bond returns the original sum of money to the purchaser of the bond (i.e. you).

Bonds can be issued by many different entities. Typically, bonds may be issued by the central government, local governments, government bodies, corporate entities, etc. Bonds issued by the central government are often seen as the most risk-free instruments in the market, which is why the rate of return offered by these instruments is often used as the benchmark to measure and evaluate returns offered by other instruments.

What are the benefits of investing in bonds?

Bonds have many attractive features for investors. For one, they offer a lot of flexibility.

More secure than other investments

Bonds are also typically more secure than equity investments, and government bonds may even be considered to be risk-free. Due to their low-risk nature, investors looking for safer investment options and capital protection are often attracted to bonds.

Low-risk

As bonds are relatively low-risk instruments, they tend to offer lower returns than the returns expected from equity. However, bonds generally offer much higher returns than cash equivalents (such as money market securities, etc.). It’s also useful to note that in the case of bonds, the returns offered are known in advance, unlike in the case of equities. But in the case of bonds, the returns offered are declared at the time of issue of the bonds, making it easier for you to estimate your returns and plan for the future.

Different periods of maturity

Different bonds carry different periods of maturity. While some bonds have a period of maturity of just two to three years, other common bonds may have periods of maturity of as long as 30 years. Due to this feature, investors with different investment horizons may be attracted to bonds. Generally, bonds with longer periods of maturity offer higher rates of return than bonds with shorter periods of maturity, so, if you’re looking for higher returns you may choose to invest in longer-term bonds (i.e. in bonds with longer periods of maturity).

Traded on exchanges

Some bonds can be traded on exchanges (just like many other financial instruments) before the expiry of their period of maturity. The advantage of this feature is that it offers investors greater liquidity — at any moment, you can choose to sell off your bond and recover the money that you invested in the bond. This offers another source of profits to investors. If you sell a bond at a price higher than their purchase price, then you will have made a profit on your investment. Win! (Conversely, if you sell the bond at a price lower than their purchase price, then you might make a loss on your investment.)

High returns

Some bonds may offer very high returns. Bonds are generally considered relatively low-risk investments and accordingly, they offer lower returns than equity. However, certain high-risk bonds (for example, junk bonds) offer very high returns (as much as 50% per year and even higher). And so, investors looking for higher returns can invest a part of their portfolio on such bonds. It’s important to note that such bonds carry higher default risk than other bonds so investing in such bonds is typically recommended for investors who have higher risk tolerance.

How to design an investment portfolio using bonds

Now that you understand what bonds are and the advantages they offer, it’s time to take a look at how you can design your own portfolio using bonds.

While experts often advise investors to invest some part of their portfolio in highly liquid cash equivalents, some part in low-risk bonds and some part in high-risk, high-return equity, due to the versatility of bonds, it is possible to achieve the same results using bonds only. Let’s see how this can be done.

Consider an investor who wants to invest about 20% of their portfolio in highly liquid investments, 50% in relatively low-risk investments that offer some degree of capital protection and the remaining 30% in high-risk, high-return investments. (This is one example of a balanced portfolio.)

As we mentioned earlier, some bonds can be traded on exchanges. Such bonds offer a high degree of liquidity. So, this investor can invest 20% of their portfolio in low-risk bonds that can be traded on exchanges. This would comprise a very liquid investment, which follows the investor’s plan to invest 20% of their portfolio in liquid investments. If the investor had put this money in cash equivalents (such as money market securities), they would have earned much lower returns. In this way, by investing this part of their portfolio in bonds, the investor stands to earn higher returns while also benefiting from the liquidity of these bonds.

This investor also plans to allocate 50% of their portfolio in low-risk investments that offer capital protection. To achieve this, the investor can use government bonds. As we have seen, such bonds are typically considered to be almost risk-free. Thus, the investor can invest this 50% of their portfolio in government bonds. Depending on their investment horizon, the investor can choose those government bonds whose period of maturity matches the time frame that the investor has in mind. In this case, the longer the period of maturity of the bonds, the higher the rate of return offered by the bonds would be (generally). In this instance it would be advantageous for the investor to invest this part of their portfolio in bonds with longer period of maturity.

The investor can also consider investing this 50% portion of their portfolio in a variety of bonds (mix of bonds). For example, they may choose to invest 15% of their portfolio in 10-year government bonds, 15% in 30-year government bonds and 20% in corporate bonds. Corporate bonds generally offer higher returns than government bonds. And so, investing 20% of their portfolio (out of the 50% low-risk investment portion) in corporate bonds would enable them to earn higher returns than those offered by typical government bonds.

The investor intends to invest 30% of their portfolio in high-risk, high-return investments. For this purpose, the investor can look at high-risk bonds (for example, bonds that offer returns of more than 20% — 25% per annum). The advantage of investing in these bonds vis-à-vis investing in equity is that in the case of bonds, the rate of return available (rate of return being offered) is known in advance. On the other hand, in the case of equity, the investor would have little clue as to how much returns to expect. So, investing this part of the portfolio in bonds gives the investor better control over their financial future.

This is how an investor can design a balanced portfolio using bonds only. As you now know, a balanced portfolio designed using bonds only may have certain advantages over similar portfolios designed using other instruments, and this is how an investor can benefit from the versatility of bonds.

In this example, we’ve considered investing 20% of the portfolio in bonds that can be traded on exchanges (liquid investments), 50% of the portfolio in low-risk bonds (capital protection investments) and the balance 30% in high-return bonds (high-risk, high-return investments).

Based on your personal preference, you can change these ratios to design a portfolio that matches your own investment goals. For example, if you want higher returns and are willing to take higher risk, you may invest more than 30% of your portfolio in high-return bonds (and smaller portions in liquid investments and capital investments), and so on. Similarly, you can also use bonds in conjunction with other instruments. For example, the portfolio that we explained above could also have been designed by investing 20% of the funds in cash equivalents (liquid investments), 50% of the portfolio in low-risk bonds (capital protection investments) and the balance 30% in equity (high-risk, high-return investments).

Want to learn more?

Now that you have a clearer idea of the benefits that bonds can offer, what are you waiting for? Start designing your portfolio and investing.

If you want to learn more, check out Shaw Academy’s online trading and investment courses today.