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