Now we have some idea about investing in the stock market. What about bonds, the other typical type of investment? What are the different types of bonds? How do they work? How can we make money with them and also: how can we lose money? In the followings I will explain some basics about the magical world of bonds.
Generally speaking there are two main types of bonds: government bonds and corporate bonds. By purchasing bonds, you are basically lending money to the issuer of the bond (to the government or to the company). Great, right? You lend the money and wait for it to be repaid together with interests. Sounds like a safe and easy way to earn money and generally it is. There are some downsides though.
First of all just like there are better and worse borrowers when it comes to people, there are also better and worse borrowers when it comes to governments and companies. You can lend your money to the US, German, Dutch government and you can lend it to countries like Venezuela, Argentina etc. You can lend it to companies like Apple or you can (could) lend it to Lehman Brothers.
Wait, so can we lose money on bonds?
Under the most simple scenario we purchase a bond, we hold it until maturity (can be 1, 5, 10 etc. years), collect the interest it pays during the agreed periods and at the end we also get back our initial amount we lent. Everyone is happy. But what happens if we want to sell our bonds earlier? No, problem, we can do that. But for how much?
During the lifetime of a bond, many things can happen. Let’s say you purchased a zero coupon bond for a par value of EUR 1,000 for EUR 970. This represents a 3.09% yield. After a while the company is getting into a bit difficult financial situation. The investors see it, so they are willing to purchase its newly issued bonds only for a cheaper price (e.g. EUR 950) in order to reflect their increased risk. The EUR 950 bond price represents a 5.26% yield. What will happen to the price of our bond? It will of course also drop; nobody would be crazy to buy it from you for EUR 970 when they can buy for EUR 950. See? Price drop means yield increase and vice versa.
It’s not only fundamental changes on the side of the bond issuer that can cause yield/price change during the maturity of the bond, but it can also be caused by external factors. Let’s take a super secure bond: 10 years US/German etc. government bond. You can be pretty sure you get your money back plus they also pay the coupons. Let’s say this bond yields 1%. You would of course would not purchase a bond of a stable, but maybe not rock solid company for the same yield; you want to get some premium for your increased risk. So this company is able to issue its bonds with 2% yield let’s say. What will happen when the FED/ECB will increase the prime rate? The yield of their newly issued bonds will also increase, so will the yield of the bonds of our fictive company, even though the fundamentals around it might not have been changed at all.
Calculating bond prices are actually a bit more complex, but the above might give you a good idea on the general principles behind it. As an average investor it might be sufficient to keep three principles in mind:
- When the yield goes up, the price goes down and the other way around
- The longer the maturity is, the bigger effect the same yield change has on the price
- The lower the yield is, the bigger effect the same yield percentage change has on the price
So are you expecting the increase of the yields? Short term bonds (especially already higher yielding ones) are the better choice. Are you expecting the decrease of the yields? Lower yielding long term bonds are the ones for you. Have a look at the below chart:
This is the comparison of the performance of three bond ETFs over the last 5 years (low, declining interest rate environment). The blue line represents iShares 1-3 Year Treasury Bond ETF, the purple one iShares 7-10 Year Treasury Bond ETF and the orange one is iShares 20+ Year Treasury Bond ETF. Note not just the performance of the price, but also the higher volatility that comes with longer bonds. Bear in mind that in an increasing interest rate environment the volatility will be similar, but the performance will be inverse…
Do you have questions? Do you agree or disagree? Anything to add? Feel free to post your comment below!