How to buy bonds and make money from them?
Are you curious about the best method for buying bonds? In this article we will discuss the best method to invest in bonds. This way you will immediately discover the various ways in which you can make money with bonds.
What are bonds?
Bonds are debt securities issued by a company (corporate bond) or government (government bond). When the term of the bond expires, you will receive the amount of the bond back: this is also called the redemption value. Over the period that you hold the bond, you also receive an interest payment, which in the case of bonds is called the coupon rate.
Just like shares, bonds can be traded freely on the stock exchange. The prices of bonds may therefore fluctuate depending on the demand for the specific bond.
Where can you buy bonds?
If you want to make money buying and selling bonds, you first have to know where you can do this. You can easily trade bonds and bond funds at an online broker. There you can buy bonds of well-known companies and governments.
A good Dutch broker for buying bonds is DEGIRO. DEGIRO is a reliable broker where you can buy bonds at low rates. Moreover, at DEGIRO it is possible to trade in bond funds without buying and selling costs, when they are listed in the core selection. Use the button below to open an account at DEGIRO immediately:
What do you want to know about buying bonds?
- Methods: what ways are there to trade bonds?
- Understanding bonds: how to read a bond?
- Making money: how to make money with bonds?
- Timing: when is it smart to buy bonds?
- Types of bonds: what type of bond can you buy?
- Risks: what should you look out for when buying bonds?
- Price formation: how does the price of a bond come about?
How can you trade bonds?
You can choose to open individual bonds or invest in a fund that buys & sells bonds on your behalf.
Buying individual bonds
The first possibility to invest in bonds is to buy individual bonds. Bonds can be bought from most internet brokers whereby you pay transaction costs that are comparable to those you pay when buying shares. When buying individual bonds, it is important to pay attention to the term, current price, nominal value and interest rate.
Sometimes it is also possible to subscribe to an issue. You then receive the bonds at the issue price, which can be especially attractive when the bonds are issued below nominal value.
Investing in bonds with a mutual fund
It is also possible to invest in bonds with an investment fund. There are many possibilities within an investment fund. Often you can determine in which regions. Currencies, credit ratings, maturities and sectors you want to invest in. There is a taste for every investor. In this way, you do not buy the bond but a participation in the fund.
A major advantage of investing in bonds by means of a fund is that you can apply more diversification. It is often expensive to add spread to your bond portfolio on an individual basis. Government bonds are issued for a minimum of $1,000 and for corporate bonds this can rise to a minimum investment of $50,000. By applying diversification, you reduce the risks. The bankruptcy of one company, for example, does not immediately lead to the loss of the entire investment.
A disadvantage of an investment fund compared to buying bonds yourself is the fact that you often pay management costs. With individual bonds, you only pay the transaction costs. With a fund, however, you also have to pay the manager of the fund. This, of course, is at the expense of the ultimate return. If you have the capital to purchase the bonds individually, this may be the most advantageous choice.
Which option is best?
This depends entirely on your personal preferences and wishes. When you buy and select bonds yourself, you can decide which criteria you use. Moreover, buying individual bonds is cheaper than buying a participation in an investment fund: an investment fund charges management fees.
Yet, an investment fund can also be very attractive. Normally, bonds cost at least 1,000 pounds, but within an investment fund, you can already participate for a few pounds. In addition, you leave the difficult decisions out of your hands, which saves you time, and that is also worth something.
How to read bonds?
When you want to buy bonds, you must understand how to read a bond. A bond is often indicated in this way:
NL 0.75% 2027/07/15
The letters stand for the authority behind the bond. In this case, it is a government bond issued by the Dutch government. The percentage then indicates the coupon rate you receive and the date is the expiry date on which the amount is repaid. On every stock exchange, there is also a price for the bond.
This indicates how the value compares to the nominal value. The nominal value is indicated as 100 and this is the sum that you, as investor, will get back on the maturity date. So, in this case, this bond is trading at 4.03 per cent above its nominal value. Now you know what to look for before buying a bond.
Calculation example for a bond investment
Let’s use a mathematical example to show how an investment in a bond works. In this example, you decide to buy a government bond that pays coupon interest on 1 June and matures in 2 years. The price of the bond is currently 102%. The denomination is $1000 and the annual interest rate is 5%.
To purchase the bond, you now have to pay $1000 X 102% which comes down to $1020. At the end of the term, you will receive the nominal amount of $1000 back. Per year, you will also receive $50 in interest.
The coupon return in this case is $50 / $1020 (the amount you actually paid). This amounts to 4.9%. When the effective yield is taken into account, you also have to look at the remaining term. In 2 years’ time you receive twice $50 in interest which is $100. You do make a loss of $20 because you bought the bond for an amount higher than the nominal value.
In two years’ time, you will thus achieve a return of 8% and, on an annual basis, the effective return will be 4%. Before you buy a bond, it is important to calculate these numbers. That way you know whether it is wise to buy a bond.
Making money by buying bonds
If you want to make money by buying and selling bonds, you must understand what factors influence the price of a bond. These are mainly the market interest rate and the creditworthiness of the bond. In the article Investing in bonds you can read in more detail how the price of a bond is established.
The simplest way to make money by buying bonds is by holding them. This is because you receive interest on the bond and this amount is credited to your investment account every year. If you buy bonds at the beginning of the term for the interest, the price makes little difference as you will receive the full nominal amount back at the end of the term.
More active investors can choose to actively buy and sell bonds. If you do this well, you can make more money. It is important to predict the price movement of the bond. You do this by thinking about two things:
- Will the market interest rate increase or decrease in the future?
- Is the creditworthiness of this bond increasing or decreasing?
A falling market interest rate and a rising creditworthiness increase the price of a specific bond. By making good deliberations, you can buy the right bonds that will give you a good price return before maturity. Good luck with buying bonds!
When is it smart to buy bonds?
Depending on your investment strategy, it may be smart to buy bonds. For defensive investors it can be interesting to invest in bonds. Bonds are seen as relatively safe, because they are repaid at the end of the term. If the underlying party goes bankrupt, however, you can still lose your entire investment. But especially in the case of government bonds, the chance of this is minimal.
By buying bonds, you can also improve the risk diversification of your investments. By investing in different types of investment products, you reduce the chance of losing a lot of money when one investment category performs less well.
Bonds can be a good alternative for savings products. Especially when you have a large capital, these days you may even receive a negative interest rate on your savings.
What types of bonds can you buy?
The most secure bonds are government bonds: these are issued by the government. The chance that the government as a whole goes bankrupt is fairly small. Of course, this chance increases when you buy bonds from a less stable economy.
Bonds of high-quality companies with a good credit rating are also low risk. These bonds are also called investment grade and have a rating from AAA to BBB-.
You can also choose to buy bonds from less creditworthy companies. These bonds are popularly known as junk bonds or high-yield bonds. The interest on these bonds can quickly rise to ten percent or more, but there is also a greater chance of losing your deposit.
What are the risks of bonds?
Buying bonds is safer than buying shares: this does not mean, however, that there are no risks associated with investing in bonds. The most obvious risk is the credit risk: if the party behind the bond goes bankrupt, you can often kiss your money goodbye.
There is also a price risk: because the price of a bond can rise and fall, your investment may be worth less. This is not a problem if you hold the bond until the end: you will still receive the original amount of the redemption value.
Another risk is a more technical one, namely the inflation risk. You receive a fixed payment in coupon interest and redemption, but the real value of this money may decrease. This happens when the general price level rises. You can then buy fewer products or services with the same amount of money.
Finally, when you buy bonds from foreign parties, you also have to deal with the currency risk. The other currency can then become more expensive, as a result of which you receive less money back in your currency.
If you care about the environment, you can choose to buy sustainable bonds. Sustainable bonds or green bonds are used to finance environmentally friendly projects. In many countries you will also receive tax benefits when you invest in green bonds.
What kind of bonds can you buy?
In addition to the standard bond, there are also special types of bonds. You must understand how the bond works before you buy it.
- Zero-coupon bond: you receive no interest on the bond. The bond is often issued at an amount lower than the redemption value.
- Convertible bond: this bond can be converted into shares under certain conditions.
- Perpetual bond: a perpetual bond has an unlimited duration. You always receive interest on the bond, but the original sum is never repaid.
- Indexed bonds: this type of bond is ideal if you fear strong inflation. The return on your bond is adjusted to the annual inflation.
How is the price of a bond determined?
The price or rate of a bond often depends strongly on the interest rate development. It is therefore smart to take the interest rate into account when buying a bond.
When market interest rates rise, bonds often decrease in value. This is because the same bond with 2% interest is less attractive when you receive 1% savings interest than when you receive no savings interest.
Other investment products also influence the price of a bond. For instance, are shares performing much better than bonds? Then the prices of bonds may fall at the expense of the prices of shares.
Another factor that can influence the price of a bond is the creditworthiness of the underlying entity. If the probability that the underlying party cannot repay the money increases, you will see the price of the bond fall.
Conclusion: how to make money with bonds?
You can make money with bonds in two ways: you can make money by profiting from the interest payments until the end of the term. In this way, you receive a fixed and reasonably secure income.
The second way you can make money with bonds is by selling the bond with a price profit. To accomplish this, you need to properly assess the market and the demand for the specific bond.
In any case, it is important to remember that there are no safe investments. Bonds have the image of being safe, but still carry the necessary risks. Therefore, investigate whether buying bonds is wise in your situation.
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When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.