Investing in bonds: What is it and how do you do it?

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Investing in bonds can be a smart way to grow your wealth. Unlike stocks, where you become a co-owner of a company, with bonds you lend your money to companies or governments. In this article, you will learn everything about what bonds are, how they work, and which types you can consider. You will also read how you can start at BUX.

Bonds: meaning in brief

Bonds are tradable loans issued by a company, government, or other organisation. As an investor, you lend money and receive periodic interest (coupon rate) in return. At the end of the term, the invested amount is repaid. Bonds can have different maturities and conditions, and typically offer lower risk than stocks, although there are always risks involved.

What is a bond?

A bond is a tradable debt instrument issued by a country, government organisation, or company. You can invest in that loan. As an investor, you lend your money out, and in exchange, you receive an agreed interest payment at a fixed moment (for example, annually). This is called the coupon rate. At the end of the bond’s term, you get your invested amount back.

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Important terms regarding bonds

Before we dive further into the matter, it is important to know the meaning of a number of terms. This way, you will better understand how bonds work.

• Principal: This is the amount you receive back from the issuing entity on the maturity date of the bond. In most cases, the principal is equal to the nominal value of the bond. You receive your invested amount (excluding interest) back in full, unless the company goes bankrupt.
• Coupon rate: This is the interest you receive on the principal of the bond. Suppose you buy a bond of €1,000, then with a coupon of 5% you receive €50 per year. Most bonds have a fixed interest rate, which means the amount you receive remains constant. However, there are also bonds with a variable interest rate; these are also called floating-rate notes.
• Nominal value: The nominal value is the value you get back on the maturity date, so equal to the principal.
• Bond price: This is the price at which the bond is traded on the market and can deviate from the nominal value. This price is expressed as a percentage of the nominal value. When the price is equal to the nominal value, the bond is traded ‘at par’. Is the price below the nominal value? Then it is ‘below par’. If the price is above the nominal value, then it is ‘above par’.
• Maturity date: This is the agreed date on which you get the principal of your investment back. Deviations occur, for example in the event of a bankruptcy.

What types of bonds are there?

There are different types of bonds. Each type of bond has its own characteristics and risks. The most popular are government bonds and corporate bonds. In addition, there are other bond types. Let’s have a look at those.

1. Government bonds

A government bond is often a long-term bond issued by a country or government agency. The borrowed money is often used for projects such as infrastructure or covering budget deficits. Government bonds are seen as relatively safe, but they still carry risks, especially if a country is economically unstable.

2. Corporate bonds

A corporate bond is issued by a company and is often used to facilitate growth. For example, to buy properties or hire people. These bonds carry more risk than government bonds. This is because, with a company, it is less certain that a loan can be repaid. You are therefore dependent on the financial health of the company.

Other bond types

Besides government and corporate bonds, there are more types of bonds, namely:

• Convertible bonds: You can convert these bonds into stocks of the same company under certain conditions.
• Callable bonds: With these bonds, the issuing party can buy back the bonds before the end of the term. They therefore have no fixed term. That is why they are also called ‘early redeemable bonds’.
• Floating rate notes: Floating rate notes have an interest rate that moves with the current market interest rate. Therefore, they are called ‘bonds with variable interest’.
• Perpetual bonds: These bonds have no fixed end date. You receive an annual coupon unless the issuer decides to buy back the bond.
• Subordinated bonds: These bonds have a lower priority level for repayment in case of bankruptcy, which makes them riskier, but often the expected return is higher.
• Bond funds (ETFs): With bond funds, you can invest in a basket of bonds, which helps to spread risks.
• Index-linked bonds: These are bonds where the coupon rate depends on a certain index. For example, based on inflation.

How are the price and value of bonds determined?

The price and value of bonds are influenced by various factors. These are market conditions, interest rate policy, potential risk, maturity, and rating. 

1. Market conditions

The price of bonds is strongly influenced by market conditions. Take the stock market, for instance. Suppose the stock market is on an upward trend. Then it is more attractive for investors to invest in stocks, causing the value of bonds to fall. The reverse is also possible. When stocks are less attractive, it is more likely that investors will put their money into bonds, which can increase the price.

2. Interest rate policy

The interest rate policy also affects the value and price of a bond. An existing bond with a fixed coupon rate becomes attractive if the interest rate falls. As a result, demand and price rise. On the other hand, when the market interest rate rises, the fixed coupon rate becomes less attractive. The price of an existing bond falls.

3. Potential risk

Additionally, potential risk is an important factor in the value of a bond. When it is believed that there is an increased risk, for example, if a company or government cannot meet obligations, the value of a bond may fall. 

4. Maturity

Another factor is the maturity. Bonds with a longer maturity typically offer a higher coupon rate than bonds with a short maturity. A long maturity is, for example, ten years, and a short maturity is one year. This is because investors lend their money for longer and therefore expect a higher interest rate.

5. Credit rating

Finally, the rating. Credit rating agencies give certain bonds a rating to assess the creditworthiness of the issuing party. These ratings vary from high creditworthiness (AAA) to low creditworthiness (D). The higher the creditworthiness, the higher the value of a bond. And conversely, with low creditworthiness, the price and value of a bond are lower.

Can you earn money by investing in bonds?

As an investor, you can effectively achieve returns with bonds. This can be done through coupon rates or price returns.

1. Coupon rate

The coupon rate is a fixed or variable compensation you receive for lending your money. This amount is paid out periodically, usually annually or semi-annually. How high this coupon rate is depends on the creditworthiness of the issuing entity. Usually, the coupon rate for a government bond is lower than for a corporate bond.

2. Price return

You can also earn money with price return. In other words, if the value of the bond rises on the stock exchange. And you read about that above. If the market interest rate falls, the price of an existing bond rises. Do you then sell your bond for a profit? Then the difference between that amount and the purchase amount is your return.

Can you lose money on bonds?

Although bonds are considered relatively safe, there are risks involved, just as with other investment products. These are:

• Credit risk: This is the risk you can run if the issuing institutions default, cannot meet financial obligations, and do not repay the loan. So check to what extent the entity is creditworthy (credit rating).
• Interest rate risk: This risk refers to the effect of rising interest rates on the value of bonds. When interest rates rise, existing bonds become less attractive, causing their price to fall.
• Currency risk: This risk arises from fluctuations in the exchange rate between the currency of the bond and your own currency. If the value of the foreign currency falls compared to yours, your return may become negative.
• Bankruptcy: When the issuer of the bond goes bankrupt, regular bonds have priority in payment over subordinated bonds. The latter bonds therefore carry more risk because the chance of a full repayment is smaller.
• Tradability: Bonds are often traded less than stocks because institutional investors often hold them until the maturity date. Most trading takes place at the beginning of the term, but with changing market conditions, it can be difficult to get a good bid or to buy extra bonds.

Bonds vs stocks and ETFs

Besides bonds, there are stocks and ETFs. Although they are all three investment products, they are not the same. Have a look.

Buying bonds, how do you do that?

You can invest in bonds via a broker, like BUX. With us, you can specifically invest in bond ETFs, which are baskets of different bonds. You can include them directly in your BUX Investment Plan(s). Easily set up your personal investment plan in the BUX app and decide what amount you want to deposit every month. This is possible starting from €10. Then select the products that suit your goals and we ensure that your deposit is automatically invested. The only thing you have to do is choose a fixed day in the month and set your goal. This way, you build your returns and your financial future step by step.

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Investing involves risks. You can lose your investment.

All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.