Bonds: Nuts and Bolts

Let’s say you are a novice investor, not an amateur hour trader, an investor with a serious approach but a lack of profound experience. You want to build a strong, risk-free portfolio.

Concentrating on one security is a common misstep. If you plan to invest all your money in a single stock, brace yourself for failure. Instead, including various instruments into your portfolio is a good start. Try to spread your funds across stocks, ETFs, commodities and don’t forget about bonds.

Bonds are one of the safest types of securities. First, bonds are debt, whereas stocks are equity. Buying into debt is far better than buying into equity, as debt is not tied to the asset performance. Bonds fit any portfolio and help investors to sail through risks diversification process.

The principle is simple, don’t rely heavily on stocks. Diversify. Once you invest only in stocks, you end up being dependent on the market moves. The situation can become harsh when you need to pay bills and investment is the only source of your income.

Bonds are much safer. See for yourself. You are entitled to coupon payments that don’t depend on bull or bear market. After all, you can eventually get the original sum, or a principal, upon a bond maturity.

Bonds are predictable. They carry less risk compared to other equities, and they pay off with a fair level of guarantee. The flip side is that payments are not so high as stocks can be. Let’s take a closer look.

Corporate Bonds

Companies often issue bonds to attract extra capital. Such bonds are associated with credit risks. Before buying a corporate bond, it's critical to ensure a company is not balancing on the brink of bankruptcy and is able to meet its debt obligations in the future.

There are special rating agencies that are here to prevent you from lame investments. For example, Moody's. The agency keeps a keen eye on corporations and provides investors with an honest and clear ratings, so they won’t go to pieces.

Analyse yields and take into account the maturity date. A yield is a return you receive from a bond while you hold it. The maturity date is the period when you receive the final payment on your holding. It’s important to pay special attention to yields when you compare two corporate bonds. Investors tend to pick up those with a longer maturity and higher yield. That means that a four-year corporate bond with a 7% yield will be more attractive to investors than a ten-year corporate bond with a 5 % yield. But that’s not a rule of thumb, nor it a tendency.

Factors that help us to make the right corporate bond investment are aplenty. It’s important to take into account everything that can affect your future payments.

Mortgage Bonds

Just like corporate bonds, mortgage bonds have credit risks. Nevertheless, they remain very alluring to investors as these bonds are backed by mortgage.

Let’s have a look at what stands behind mortgage bonds.

For example, when you purchase a house and pay with a mortgage. A person or institution that lent you money sells the mortgage to investment bank or other entity. You start to repay your mortgage. A share of your payments is used to pay the yield on a mortgage bond. Thus, mortgage bond is safe and generates income as long as you make regular payments. If you become unable to meet your debt obligations, the bondholder has a claim on your property.

That’s the theory. In practice, things are a bit more complicated. There is a prepayment risk when a sum that is supposed to be a final payment is paid ahead of the schedule. Alternatively, there is an extension risk when a maturity date is postponed because borrowers cease to pay.

Governments Bonds

As the name implies, these are bonds issued by the government. They are called ‘gilts’ or Treasury Stocks in the UK. They are issued in domestic currency and considered to be risk-free debt instruments. Still, there have been precedents when a country defaulted on its home currency debt (‘ruble crisis’ in Russia in 1998). UK government bonds have a longer maturity compared to their European counterparts.

Although they are considered safe, risk-free and secure, government bonds can bring nasty surprises to their owners in the case of inflation.

What’s It All About

Including bonds in your portfolio can help you spread risks, if not reduce them significantly. While the stock market can be volatile and unstable, bonds are solid and healthy investments. Nonetheless, allocating bonds in a portfolio doesn’t mean you can rest on laurels and wait for payments. Far from it.

Prepare, analyse and research before buying in this type of debt instrument. After all, no investment strategy is safe from risk. That’s the very basic rule.