Invest in Bonds - What Are Bonds, How Can You Earn Money from Bonds?

A bond is a debt security in which the issuer (the entity issuing the bond) borrows money from an investor. In return, the issuer guarantees to repay the investor the bond's face value (or nominal value) and provide interest payments (coupon income) in the future. It's similar to a loan: a company or government seeks funds for its needs, and investors lend them money in exchange for interest.

Why Should You Consider Buying Bonds?

Bonds, also known as fixed-income securities, are considered conservative financial instruments. They are often compared to deposits, but bond yields typically exceed deposit rates.

Bonds offer fixed terms, meaning the issuer is obligated to pay interest (coupon) at specific intervals and in a fixed amount. Investors can plan their cash flow accordingly and understand how to earn money from bonds and what returns they can expect.

However, it's important to note that bonds trade on the market, making them subject to volatility. During economic crises or when interest rates rise, bond prices decline. If an investor needs to sell their bonds during such periods, they may have to do so at lower prices. Conversely, during periods of declining interest rates, bonds generally increase in value, allowing investors to sell them at a profit.

How do Bonds Work?

Typically, when the central bank's key interest rate rises, bond prices decrease, and when the key interest rate falls, bond prices increase.

The main advantage of bonds is predictable cash flow. This applies to situations outside of crises and force majeure events. However, it also leads to the main drawback: in the event of default, the probability of recovering investments is extremely low. Furthermore, bonds tend to respond to negative events more quickly and severely.

Pros of bonds:

  • Guaranteed income.
  • Higher returns compared to deposits.
  • The flexibility to invest for any term.
  • Accrual of interest income for each day of ownership.
  • Accrued interest income is not lost when selling before maturity

Cons of bonds:

  • Subject to volatility.
  • Risk of a decrease in nominal value.
  • Dependence on inflation and central bank rates.

Types of Bonds

There are several types of bond classifications:

By issuer type:

  • Government bonds.
  • Corporate bonds (issued by companies or organizations).

By time to maturity:

  • Short-term (up to 1 year).
  • Medium-term (1 to 5 years).
  • Long-term (over 5 years).

Perpetual or perpetual bonds (no fixed repayment period, provide constant income, similar to preferred shares).

By income type:

  • Coupon bonds (fixed and guaranteed coupon payments at specific intervals. The interest rate is known from the time of issuance, allowing for accurate calculation of investment returns until maturity).
  • Discount bonds or zero-coupon bonds (no coupon payments, issued at a price below the nominal value, and the return is based on the difference between the purchase price and the redemption/sale price).
  • Floating-rate bonds (coupon rate changes based on market conditions).
  • Variable-rate bonds (interest rate tied to an indicator such as the central bank's key rate, consumer price index, exchange rate, etc.)

By currency denomination.

How to Choose Profitable Bonds: Key Principles

The attractiveness of the bond market depends on the type of investor. For speculators seeking high returns, bonds may offer limited opportunities, but for conservative investors who typically compare them to deposit rates, there are plenty of investment ideas in the debt market.

How to Invest in Bonds Properly

When choosing bonds, it is necessary to pay attention to the coupon rate, price, yield premium to government bonds, call and maturity dates, bond liquidity, and issuer reliability.

Bonds have different maturity dates and different methods of accruing coupon income. When choosing bonds, it makes sense to rely on expert recommendations. You can consult your broker or find recommendations from analysts at major banks, which are published on websites, mobile applications, and bank Telegram channels.

The main part of the portfolio should consist of bonds issued by large reliable companies with high ratings. This will allow you to create a stable portfolio that generates consistent profits through coupon income.

You can also pay attention to smaller state-owned companies, whose yields may be higher than those of large issuers, as well as the banking sector. Additionally, you can consider investing a small amount of funds in high-yield bonds. Such companies carry increased risks but can provide higher returns. Investment in developer bonds is also worth considering. The allocation of different assets is chosen based on risk: the lower the risk of losing funds, the higher the share of bonds in the portfolio, he explains. Therefore, the foundation of the portfolio consists of bonds with low issuer default risks.

Regarding the choice of bond maturity, investors should also diversify based on their investment goals. You can use the rule that the higher the company's risks, the shorter the maturity of the bond should be.

The only bond instrument without credit risk is government bonds, but they trade at the lowest yield. Corporate bonds offer higher returns.

It is also important to consider tax implications. While no personal income tax is paid on deposits, the entire income from bond investments is subject to taxation.

What to Consider When Choosing Bonds

When choosing bonds independently, diversification is important. It is desirable that no more than 5% of the bond portfolio is allocated to a single issuer. However, reducing the share to 1% or lower is also not preferable: having too many names makes it difficult to track potentially problematic cases. In general, monitoring the portfolio becomes quite difficult, so the risk of default increases.

It is also helpful to keep a portion of the portfolio (about 10%) in cash. These funds can be placed in risk-free, highly liquid instruments, earning returns close to the key rate, while always having money on hand for interesting purchases when unexpected market opportunities arise.

When buying corporate bonds, it is important to pay attention to several parameters.

It is important to know the issuer's credit rating, but one value is not enough: it is worth reading the rating press release, as it may contain information about potential issuer risks. It is also necessary to look at the rating trend: if it is decreasing, it likely means the company is facing difficulties, even if the absolute rating value is acceptable at the moment.

It is worth studying the issuer's debt repayment schedule: if there is a peak of repayments in the near future, the risk of default increases. It is preferable for the repayment schedule to be smooth, or for major payments to occur in later periods.

It is useful to subscribe to specialized bond chats and channels: they provide up-to-date information on companies, enabling more informed decision-making.

Do not solely purchase bonds based on yield; before each purchase, it is important to study the issuer and its financial condition. High yield does not always indicate imminent default; it may be due to market inefficiency or peculiarities of terminal display. However, at the very least, it should serve as a signal for cautious consideration.

It is worth tracking not the coupon yield, but the yield to maturity or current yield: if the price of bonds falls, the yield increases in terms of the purchase price. So even bonds with low coupons can turn out to be quite profitable, and vice versa.

It is important to review the terms of the bond issuance to understand the pitfalls. Investors should ask themselves the following questions: What are the conditions for determining the coupon rate? Are there embedded options? What is the term to maturity, coupon payment frequency, and amortization? Are there any guarantors and sureties? Are there any covenants? The more an investor knows about the financial instrument they are buying, the better protected they are against unpleasant surprises. Then the risk needs to be compared with the offered yield.

It is useful to look at how similar companies are performing - this will provide a general picture. It is important not to forget that coupon yield and yield to maturity are two different things. Yield to maturity is calculated based on the current price of the bond, coupon rate, frequency of coupon payments, and most importantly, assumes reinvestment of coupons, which effectively leads to an overestimation of the indicator.

Novice investors can pay attention to bond funds that perform the described work for investors and offer an immediately diversified portfolio.

How Bonds Work: The Basics

A bond is like a loan: a company or government seeks money for its needs, and an investor lends it at interest and receives fixed income.

Advantages of Bonds

  • Guaranteed income.
  • Higher yield compared to deposits.
  • Ability to invest for any term.
  • Accrual of interest income for each day of ownership.
  • Accrued interest is not lost when selling before maturity.

Disadvantages of Bonds:

  • Subject to volatility.
  • Risk of decrease in nominal value.
  • Dependence on inflation and the central bank rate.

Bonds are classified based on:

Issuer type:

  • Government;
  • Regional and municipal;
  • Corporate bonds.

Term to maturity:

  • Short-term (up to 1 year);
  • Medium-term (1 year to 5 years);
  • Long-term (over 5 years);

Perpetual or undated

Type of income

  • Coupon bonds;
  • Discount or zero-coupon bonds;
  • Variable coupon bonds;
  • Floating rate coupon bonds.

Currency denomination

When choosing bonds, it is necessary to pay attention to the coupon rate, price, call and maturity dates, bond liquidity, and issuer reliability. The main portion of the portfolio should consist of bonds issued by large reliable companies with high ratings.

Henry Smith


calendar icon 20.02.2024

Independent financial analyst. He is a financial adviser for a number of investment funds.

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