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Investing in bonds for beginners

In this day and age, a lot of us have become accustomed to borrowing money in some capacity, whether it is getting a home loan, or even borrowing a couple of Euro from a family member when realising you have left your wallet in your car. Just as borrowing has become a part of individual life, it has become a practice that companies and governments make use of as well, but many people still do not understand what it entails. How can these entities borrow money you may ask? One way would be by issuing bonds.

Bond issuers come in all shapes and sizes, be it; corporate, government, structured finance etc. These entities will be collectively known as ‘issuers’ within this article. Although these bonds might vary in features, at their core they still have the same purpose. The purpose behind issuing bonds is to raise capital for specific activities – they are basically debt instruments. The ‘issuers’ promise is to pay back that debt, plus interest, over a predetermined period of time. Here, we will be explaining the advantages and disadvantages of bonds, how they work, how to make money from bonds, how to evaluate them, and if bonds are the right choice for you.

 

How do bonds work?

From an investor’s perspective, bonds are defined as lending money to ‘issuers’ who issue the bond and hold it for a predetermined period of time. Formally, they are financial obligations of an entity which promises to pay a coupon at stated interest payment dates (this is typically the annual or semi-annual interest payment that the bondholder receives from the bond’s issue date until it matures). When the bond reaches the date of maturity, the issuer repays the principle, or original amount of the borrowed capital.

To give an example, a well-known and established private company in Malta issues a 10-year, Eur10,000,000 corporate bond with a 4% coupon. If you choose to apply for the bond and invest Eur25,000, in ten years’ time the company will return your Eur25,000, and for every year until then, will pay you Eur1,000 interest.

 

How do I generate cash from investing in bonds?

Generally, a fixed rate bond has two sources of return:

  • Receipt of the promised coupon (interest) on the scheduled dates and principle (capital) payment upon maturity.
  • Potential capital gains or losses on the sale of the bond prior to maturity. For example, you bought Eur1,000 worth of bonds at nominal value, and after some time you sell it for Eur105 when the market value increases. This transaction will generate Eur50 worth of profit by selling that bond, which would be seen as a capital gain.

 

What type of bonds are there in Malta?

As stated earlier on, bonds come in a variety of options. The majority of bonds issued on the local market are known as bullet bonds (the plain vanilla type of bonds), although there are also a number of callable bonds which give the issuer the opportunity to redeem the bond at a predetermined date before maturity. Bonds may also be secured/unsecured against specific asset/s within the issuer's group, which would likely give an investor added assurance to his investment. This would mean that if an issuer had to default, the bondholder would have first preference to the funds received from the sale of the secured asset, to be able to pay back the principle to the bondholder.

A further distinction can be done for the Maltese market and the different types of bonds by means of the issuer:

  • Corporate bonds, are issued by corporate entities to raise capital for business operations. These operations may range from product research to marketing – this information would be listed in the prospectus. More often than not, corporate bonds yield higher interest rates than government bonds, the latter being deemed to be more secure.
    These corporate issuers would want to raise debt as part of their overall capital structure. The most popular forms of finance from which companies raise debt are by means of a bank loan and bonds.
  • Government bonds AKA Government stocks, as the name implies, are issued by the state to finance public projects or offer civil service. While the perception of government bonds are ones which relate to ‘peace of mind,’ one must take note of the underlying credit risks within these governments. The rule of a low yield/coupon rate to be equal to a low risk can get pretty flexible, and solely depends on the government itself. That said, the interest on government bonds are typically lower than corporate bonds. These are considered to carry a lower risk than corporate bonds, since the government is ultimately deemed to be more stable in the longer term than corporations.
    National governments around the world issue different types of bonds, such as fixed-rate bonds, bonds with a floating rate of interest (interests that reset periodically based on changes in the level of the reference rate) and inflation-linked bonds (cash flows which are adjusted for inflation).

 

How do I evaluate whether a bond would be a ‘good investment’?

Bonds are considered safer than trading in equities, but this does not mean that there aren’t risks associated with investing in bonds. There are 4 great ways to indicate the actual worth and likelihood of market growth for that bond. These are listed below:

  • Corporate bonds: Quality of issuer
    As stated above, typical corporate bonds yield higher rewards, but this would mean a greater risk. An indicator one must take note of, is which company is issuing the bond in the first place. Knowing, or being familiar with the company and understanding the industry within which it operates can give the investor probable foresight on whether the corporate bond will be repaid upon maturity. In financial terms, it is known as the ‘character’ of the company. Credit analysts make judgements about management’s character in the following ways:
    1. Assessing the credit worthiness (whether the issuer is highly geared/leveraged). 
    2. Assessing their financial track record, financial soundness and cash flow situation.
    3. Assessing the soundness of management's strategy. 
    4. Use of aggressive accounting policies and/or tax strategies.       
    5. Their reputation, and if they've previously committed fraud or malfeasance. 
    6. Previous treatment of bondholders during other bond issues. 
  • Government bonds: The economy
    As stated above, typical government bonds yield low rewards when compared to corporate bonds, since risk is perceived to be lower. Nevertheless, a risk is a risk, and governments do falter. A clear indicator of the government bond’s worth is reflected in its economy and its GDP. Also, if you are investing in a government bond with a country that you do not know a lot about, it is recommended that the prospective bondholder reads up on that country.
  • International bonds: Bond ratings
    A bond rating is a score that measures the financial strength of the entity issuing the bond. There are a number of agencies that rate bonds, and each use a different combination of letters and numbers to reflect the worthiness of the security/company. The big three credit rating agencies are: Standard & Poor’s (S&P), Moody’s and Fitch Group. Although a bond’s rating can give you a good indication whether or not the bond is a good investment, it’s not a perfect system. Time passes and things change, a bond with a strong rating one year can go plummeting to the bottom of the pile just in a matter of days.
  • All bonds: Coupon rate
    One of the most important things to consider when purchasing a fixed income security is the coupon rate of the bond, this of course depends on multiple factors. Given bullet bonds, the coupon rate is paramount, but the purchase of that bond is based on the risk profile of the prospective bondholder. As previously mentioned, another aspect which is related to the interest is if the bond is secured or unsecured.  

 

Benefits of investing in bonds

Investing in bonds is relatively a less volatile investment when comparing it to investing in equities. Bond values don’t fluctuate as much as stock prices do. Another benefit is that bonds offer a predictable income stream – due to the fact that bonds pay a fixed amount of interest. One last benefit is that governmental bonds offer the chance to invest in communities, which can help you in return – giving you another incentive. Let’s give an example; a government bond is issued to help the council build a school in your neighbourhood. You invest in that bond, get the coupon, while also sending your child to that school and reaping the benefits of the governmental investment.

 

Drawbacks of investing in bonds

While there are plenty of great reasons why someone would want to invest in bonds, there are some disadvantages one should be aware of. One aspect is the perception of locking in your investment for an extended period of time. While people can sell bonds off, the ease of selling equities off is a much easier process (depending on the market). Another drawback, in some cases of course, is the regular income stream given when investing in regular bonds. In comparison, the return on investment you get when trading in equities is substantially higher than what a person can get with bonds – this drawback ultimately depends on the person, their preferences, and at which stage they are in their life.

Something else which can come up if you buy a bond is interest-rate risk. Let’s give an example; you decide to purchase a 10-year bond paying the bondholder a 3% coupon rate. After a couple of months, a new bond is issued with the same term at 4% interest rate, this might cause the bond you invested in to drop in value.

 

Are bonds the right decision for you?

This really depends where you are in your life. Clearly, bonds have their advantages and disadvantages – like any other investment. If you’re in a place where your portfolio consists of equities, bonds might be a good way to diversify whilst also protecting yourself from market volatility.

If you are cautious on the level of risk you are willing to take, bonds might be a suitable investment for you. However, the safer approach to keep your money secure would be having your cash in the bank (all factors remaining constant), but bonds pay better interest rates than your current and savings account. The choice to invest in a bond will inherently yield a better risk-return trade-off.

If you’re a retiree, or about to become retired, you may not have the time to actively monitor and trade in shares and prefer something which is more stable. Generally, bonds are a safer place to store your money in.

 

Sounds awesome! Where do I sign up?

Luckily, at MeDirect Bank we offer the chance to purchase bonds from as low as Eur10 per trade, with a wide range of corporate and government bonds to invest in. Within our platform we have integrated an arsenal of investment tools, coupled with research to support your investment decisions. With MeDirect you are secure in knowing that your bonds are in safe custody, and with a state-of-the-art payments system you will receive your coupon payments directly in your MeDirect Investment Cash Account. Sign up to our quick and easy, step by step account creation process and start investing today.

 

The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties. MeDirect Bank (Malta) plc, company registration number C34125, is licensed by the Malta Financial Services Authority under the Banking Act (Cap. 371) and the Investment Services Act (Cap. 370).
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