Growing companies often raise money for expansion by selling bonds – and this is how bonds make you money. OK, so let me expand on that a little ….. one of the ways companies like to borrow money is by selling debt securities called bonds to investors.
This article explains what bonds are and how companies can use them to raise additional money for expansion. We’ll look at how owning bonds make you money and we’ll also explain the pros and cons that bonds offer to you as an investor.
What’s a Bond?
Companies and governments all need to borrow money from time to time. They often need to borrow money when they want to expand, launch new projects or buy new assets. One way they can do this is by issuing bonds.
You can think of a bond as a loan. The borrower invites investor to loan them money in predefined amounts and predefined interest rates, promising to pay it back over a particular timeframe, with interest. If the terms are attractive, someone will come along and buy that loan offer. They lend the money to the borrower and are repaid according to the terms of the loan. That essentially is a bond.
This is basically how a bond works. In reality, companies will issue thousands of bonds at a time, each for a small portion of the total amount they wish to borrow. Investors can buy whatever quantity of bonds fits within their budget, very similar to buying shares.
Just like shares, once you own a bond, you can usually trade it on secondary markets to try and make a profit. The prices of bonds will fluctuate in response to changes in the economy – in particular, interest rates.
Thus, bonds are a way for organisations to borrow money by breaking a loan down into small parts called bonds They make these bonds easily accessible to lenders. Like shares, bonds can then be bought and sold by traders hoping to make a profit. Alternatively, you can hold the bond, collect the regular interest payments and get given your lumpsum back at the end of the bond term.
How does a bond work?
Bonds work nearly the same as a bank loan.
For example, a company wants to raise money to finance a big new project. To get the funding, the company might issue bonds to investors. In exchange for their investment, the company will promise to repay them, plus interest, within a specified time frame.
Let’s say one of the bonds they offer is a 10-year, $10,000 bond paying 6% interest. An investor will come along and decide that this is an attractive interest rate for a 10-year loan and decide to buy the bond.
This means you (the investor) have essentially loaned the company part of the capital they need to finance their new project. In return, the company has promised to make periodic interest payments on the $10,000 loan (called coupon payments) and to return the principal amount to you in 10 years.
How do bonds make you money?
There are two specific ways to make money from bonds:
The first way is to just hold the bonds until they mature and enjoy collecting the coupon payments. This means that by the time the bond matures, you will have received your initial investment back, and your profit will be whatever interest you gained during the loan period.
Bond interest can be paid semi-annually, quarterly, monthly or annually depending on the terms of the bond.
The second way you can make money from bonds is to sell them for a higher price than you initially paid. For example – say you purchased that 10-year, $10,000 bond from a company. In a year, the price of that bond may have increased to $11,000. You can sell that bond and realise the $1,000 profit.
What affects a bond price?
There are two main reasons a bond’s price might increase or decrease:
The first and most critical factor is the interest rate. If the prevailing interest rate on newly issued bonds is below the interest rate paid on existing bonds, the existing bonds will increase.
So, using our previous company example, if they started issuing 10-year, $10,000 bonds paying just 4% interest, that would suddenly make your bonds, which pay 6% interest, look more valuable to other investors.
The opposite is also true – if the company started issuing bonds paying a higher interest rate, like 8%. This would make your bond look less valuable to other investors.
The second reason a bond’s price might increase is if the issuing company’s credit rating improves. This is often true if the company had a poor credit rating to begin with, as it means it is now more likely to be able to make the interest payments on the bond.
This makes it seem a less risky investment to investors and thus drives up its price. On the other hand, if the company’s credit rating declines, it makes its bonds appear riskier and thus decreases their price.
Experienced bond traders will attempt to profit from these price fluctuations by actively buying and selling bonds on the bond markets.
Investing in bond funds
Individual bonds can be costly and are often beyond the reach of the typical retail investor. This is where bond funds come in. These funds pool together contributions from large numbers of individual investors and use the money raised to purchase a diverse range of bonds.
This is an good option if you want wide exposure to the bond market but don’t have much money to invest.
Many ETFs currently listed on the ASX offer exposure to various sections of the domestic and international bond markets. And because they trade on the ASX, you can buy and sell them just like ordinary shares.
What types of bonds are there?
There are two main types of bonds:
Corporate bonds: These are bonds issued by companies. They tend to offer higher interest rates, but there is more default risk with small, growing companies than with large, well-established companies. I’ve written more about corporate bonds previously here.
Government bonds: These are bonds issued by the US government (or UK government etc). Due to the perceived lack of default risk, they are considered safer investments than corporate bonds and therefore offer lower interest rates. Other government bonds are those issued by the US state and local governments. I’ve written about government bonds before here. Personally, I’m not a fan.
How to buy bonds
There are several options for investing in bonds.
If you want to purchase bonds wholesale, you will typically need use a broker to execute your trades for you. The broker will charge a fee. This is because most bonds are not initially publicly traded and are instead sold over the counter. Purchasing bonds wholesale can often require a large minimum investment.
Purchasing exchange-traded US Government bonds is another option if you don’t have a spare fortune sitting around. These trade on the stock market and operate similarly to passive ETFs, but rather than track an index, their returns aim to mirror a specific bond.
Pro’s of owning bonds
- Less volatile than shares: Bond prices tend to fluctuate much less than share prices, making them potentially a safer investment
- Regular Income: The coupon payments on bonds can provide a predictable and stable passive income.
- Diversification: This is the most significant benefit of investing in bonds – the diversification they can bring to your portfolio. Although shares have outperformed bonds over the long term, holding a portion of your portfolio in bonds can sometimes help reduce your financial risk.
Con’s of owning bonds
- Low liquidity: Most bonds won’t mature for five, 10, or 20-plus years, meaning that you may have to lock your money away for an extended period
- Interest rate risk: Because some bonds can have such long maturities, there is always the risk that interest rates will increase before your bond matures. Not only will that decrease the value of your bond, but it also means that if you continue to hold your bond, you may miss out on earning a higher interest rate somewhere else
- Bond Issuer default: Often unlikely, but there is still the real possibility that the bond issuer may default and be unable to meet their repayment obligations. This could potentially put both your interest payments and the return of your principal at risk
- Lack of transparency: Bond markets tend to be more opaque, particularly to retail investors, than equities markets. Because you typically need to engage a third party, like a broker, to execute trades on your behalf, you have less certainty that the price you pay or receive for your bonds is fair
- Smaller returns: Bonds also tend to offer a substantially lower real returns than shares and other riskier financial assets. This is the price you pay for a perceived sense of certainty that comes with bonds
Are bonds worth it?
Only you can answer that for you based on your circumstances and risk profile. Here are some helpful scenarios for you to consider as you decide:
- If you are a risk-averse investor who wants to lessen the likelihood of losing money, bonds might be a suitable investment for you. Because bond prices tend to be fairly stable, they usually offer a much safer store of value than shares. However, it is essential to keep in mind that your potential return is also significantly lower with bonds
- If you are already heavily invested in shares, purchasing bonds can help to diversify your portfolio and protect you against unwanted market volatility
- If you are about to retire or already retired, you may prefer a more stable income stream to help support your lifestyle. This can be achieved by rebalancing your portfolio towards bonds rather than shares.
Conclusion – Bonds Make you Money
So in basic terms that is how bonds make you money. Personally I do not hold any government bonds and stick to corporate bonds for solid passive income flow.
I hope this small article on – how do bonds make you money – gives you a basic understanding of bonds and spurs you on to do your own research. Hopefully you will figure out how bonds make you money for your circumstances.
Cheers
