Stock market investing is sexy, it’s risky, and there’s potential for significant gain (and loss!). Bond investing, on the other hand, is not at all sexy. Because of this, it’s often overlooked entirely.
You might already be a bond investor without realizing it! If you’re a KiwiSaver member, it’s very likely your scheme has at least some portion of its funds in “fixed interest securities.”
You might have scratched your head and thought to yourself “the f*$& are those?”
Fixed interest securities are any investment where the issuer must make a fixed payment at fixed times to the buyer.
They include a few other things (which I won’t go into here) but mostly your fixed interest securities are made up of bonds.
Today I’m going to give you a quick run-down of what bonds are and why they’re worth having a look at.
What even are bonds?
Just like the rest of us, companies and governments need money.
If you need $300,000 to buy a house, you can just go to the bank and get a mortgage.
However, if a company needs $300 million or a government needs $3 billion, it’s not as easy to borrow that money.
This is where bonds come in. Companies and governments sell bonds, which means they are borrowing money from the public.
A bond price is what you pay for a bond. The bond pays you interest (usually twice yearly) which is also called a coupon. The face value of the bond is then paid out at the maturity date (when the bond ends). In a nutshell, you are paying an amount to get a guaranteed return and an amount back at the end of that period. Bonds can be purchased individually or in groups with ETFs.
Sounds pretty straightforward!
What’s the difference between bonds and stocks?
Bonds and Stocks are both types of investments, but they’re very different in practice.
Like I wrote in my article on investing, when you buy shares you’re buying a small piece of a particular company.
If you bought $10,000 of Air NZ shares, you’d then own a small % of Air NZ. Because of this, you’re now entitled to a little piece of their profits (paid to you as dividends) and the price of your stocks will fluctuate based on the performance of Air NZ. The stock price might increase drastically, or it might even fall to zero if Air NZ goes bankrupt.
When you buy bonds, you aren’t buying a percentage of the company. You’re actually just lending money to the company (or government).
Unlike a share, you won’t get anything extra if that company does really well. But on the flip side, if the company loses value instead, your bond will still pay out interest at the same rate.
Over the long term bonds will typically have lower returns than stocks.
So if bonds make you less than shares, why invest in them?
As I mentioned earlier in the article, if you’re a KiwiSaver member you probably already invest in bonds.
The safer your KiwiSaver scheme, the greater the percentage invested in bonds.
Bonds are ideal for someone who needs a stable rate of return over a defined period.
This makes them a great option for people who’re getting close to retirement (or are already retired).
If you’re young and planning on cashing up your KiwiSaver soon to buy your first house, you might want to keep your KiwiSaver in a safer scheme that invests predominantly in bonds.
This will mean you don’t run the risk of your KiwiSaver drastically decreasing in value when the time comes to buy a house.
Bonds are seen as way safer and much less volatile than stocks.
Stock prices can fluctuate wildly, but bond prices will not go up or down at anywhere near the same rate (I’ll go into how much and why they fluctuate in a second)
The reason other people invest in bonds is that they can serve to “balance out” their stock investments. In times of significant economic uncertainty, investors move their money out of stocks and into bonds.
It’s called a “flight to safety” and means that while your stocks are plummeting in value, your bonds will stay healthy or even increase in value.
Do bonds have any risks?
Though bonds won’t swing wildly in value like stocks can, they do come with a few risks.
Here are a few of the major risks around investing in bonds.
Bond values move in the opposite direction to interest rates.
If interest rates fall bonds increase in value, and if they rise bonds decrease in value.
This might seem confusing, but think of it this way:
Let’s say you buy a bond which promises a 3% return for five years.
If interest rates go up, new bonds will generally pay a higher rate of return, (and the interest rate you’d get at the bank would be higher).
This means that in general, investors would look to sell bonds that pay 3% to buy bonds which pay a higher percentage.
If you wanted to sell your bond to get a fancy new higher percentage bond, it means you’d have to sell it at a lower price than you originally got it for.
On the flip-side, if interest rates go down, suddenly a guaranteed return of 3% for the next five years might be much more attractive to investors.
This means your 3% bond is now worth more since people are willing to pay more for it.
Inflation is prices increasing over time. If you buy a bond and inflation begins to increase, the real value of your bond falls. You don’t want your returns to be less than the rate of inflation, as this means you’re effectively losing money!
Inflation is pretty low right now, so if I bought a bond now at 4% return, I’d be doing pretty well.
If inflation were to rise while I had it, though, my 4% investment would start to not look so good.
I’d still be getting the same actual returns, but inflation means those returns have less value as they won’t buy as much when I get them!
The company could go bankrupt
It’s more of an issue with corporate bonds as governments are much less likely to go bankrupt. If a company who you’ve lent money to goes bankrupt, they might not be able to pay your interest, and you could even lose what you originally invested. It’s a pretty unlikely occurrence, but it does happen.
So what’re the general pros and cons of bonds?
Pros: They’re safe, easy to invest in and give you a guaranteed income. They are perfect for balancing out potential sharemarket losses.
Cons: They usually get lower rates of return than shares. Their value can be subject to interest rates and inflation, and there’s the potential risk of the company going bankrupt (though this happens with shares too)
Exercise: Have a look into your KiwiSaver. What % of it is in bonds and which bonds is it invested in?