In turbulent times, people are trying to find a "safe haven" for their hard-earned savings. Many still use deposits in the bank for this, but they are drawn to where the profitability is higher and "climb" into the depths of the financial and credit rating, going far beyond the TOP 20 of the best, that is, reliable. Thus, they greatly increase the risks of losing all their savings. But there are also more interesting and safer ways to preserve and increase the accumulated capital - this is investing in the stock market in conservative (understandable and reliable) instruments, namely bonds.
What are bonds and what are they
Bonds or, as some call them, bonds are debt securities on the stock market issued by the issuer (state, municipality, bank or company), for which the issuer is obliged to pay interest within a certain period (circulation period), as well as to fully repay the amount of debt by maturity. The yield of bonds directly depends on the Central Bank's key rate.
The debt market, or the bond market, is the most numerous in terms of the number of instruments presented. Depending on the selected parameter, a large number of bond classifications can be distinguished. We will consider the basic ones later in our article.
Types of bonds by issuer
State
The issuer is the Ministry of Finance of the State. This is the most reliable type of securities on the stock market. Government bonds are also called Treasury bonds. The yield of Government bonds is considered to be the starting point or benchmark for other debt instruments. Their profitability directly depends on the Central Bank rate and changes due to its revision by the central regulator.
Read more: What are bonds with amortization?
Municipal
A slightly less reliable tool. Accordingly, the yield on them is slightly higher than that of Government bonds - by about 1-1.5%. Regions theoretically may default on bonds, however, most likely the state in this case will help the municipality to cope with the economic situation. The reliability of the municipality in terms of the ability to meet its obligations to investors can be determined by the indicator of the region's subsidization.
Corporate
Debt securities of companies are the most common among bonds. Their reliability, as well as profitability, vary greatly and depends on the financial performance of the issuer. That is why you should carefully study the reporting when choosing bonds, not just stocks. For companies with low financial stability, the risks of paying coupons and the nominal value of securities increase.
Bank's bonds
These are bonds issued by banks. These can be credit institutions of different bank ratings: from systemically important to regional. Financial sector bonds are characterized by maximum risks. There are many parameters of bonds that are additionally worth paying attention to (offer, structurality, subordination ...).
Types of bonds by type of coupon
Fixed
The coupon rate does not change throughout the entire circulation period of the paper. According to these issues, there is a pre-known coupon payment schedule with known fixed coupon payments.
Read more: What is a bond offer?
Floating
The size of the coupon for such issues is known by any date, its size is reviewed with special frequency, and it is determined by a special formula, which usually has a macroeconomic indicator (inflation, CPI, RUONIA rate, etc.).
Types of bonds by repayment method
With debt amortization
The issuer pays the debt gradually over the entire period of the bond's circulation according to a predetermined schedule – usually the payment of part of the nominal value is made on the coupon payment dates.
Without depreciation
The entire nominal value of the bond is repaid at the end of the term – on the date of cancellation.
The listed parameters are only a small part of the possible classification features. All parameters of the bond are prescribed in the issue documents of the issue. And this is the whole difficulty – in order to choose papers for the desired parameters, it is necessary to study a large amount of information. Bonds can be selected both independently and with the help of various services.
Pros and cons of investing in bonds
Highlighting the pros and cons is a necessary need of any person with rational thinking. If everything is clear with the pros, but with the cons everything is not so clear. We have identified them, but identifying them as "cons" is not entirely correct. These are rather weaknesses or even specific features of such an instrument as bonds. And why so, we will explain further. So, let's go in order.
Read more: What is CAPEX and why is it important for an investor
Advantages of investing in bonds
High reliability. Naturally, this parameter is performed only with the correct and careful selection of issuers. Government bonds have the highest reliability, municipal bonds are slightly less reliable, then corporate ones. However, it is worth remembering that the latter can be produced not only by companies with "exemplary" financial indicators, but also with big problems. Among such securities with an increased level of risk may be bonds, which are also called "junk" - they contain the maximum potential risks.
Getting a stable income that can be predicted
The yield of bonds is formed due to two components:
- Coupon payments. Here the determining factors are its size and frequency of payments. The coupon depends, first of all, on the Central Bank's key rate at the time of the securities issue. The frequency of payments is set by the issuer and can be carried out once a month, quarter, six months or a year.
- Discount. Discount is the difference between the purchase price and the sale or repayment of a bond. Accordingly, if you bought securities at a price below par and hold it until maturity, then the issuer will still pay the debt at 100% of face value, and you will be "in the black." The market price of the bond is reflected in the broker's trading terminal and is reflected in % of the nominal value (99%, 100%, 120%, etc.). At the same time, when buying a bond, you can focus on the market price of the paper, or you can place an order with your own price.
Alternative to deposits
This option (investments mainly in bonds) is suitable for conservative investors who are not ready for risk, but at the same time want to receive income from investments above the bank deposit, thereby preserving their savings from inflation. Usually, an investment portfolio of bonds by 1-2-3-4....% outstrips the yield on deposits. At the same time, unlike a deposit, the choice of bonds with an increased level of profitability requires knowledge of the criteria for choosing reliable instruments. If the choice is made correctly, then you will receive a stable income ahead of inflation. At the same time, the variety of bonds by currency, expiration dates, coupon payment terms, coupon types, and the type of face value cancellation allows you to implement a variety of investment strategies.
Lower volatility. Bonds fluctuate much less in price than stocks. Thanks to this, they are suitable for investors who are very afraid of drawdowns in the market, want to protect their portfolio as much as possible and improve their performance in the long term.
Read more: What is Deflation: signs, causes and consequences
"Disadvantages" of investing in bonds
There is no insurance. But if we are talking about reliable bonds, for example, such as Government bonds bonds, then the state itself acts as a guarantor here. And they are even more reliable than deposits, while there is no limit on the amount of insurance.
Low profitability
This is perhaps the main argument of the opponents of bonds as an investment instrument. Compared to stocks, which can grow by tens of percent, an investment portfolio created from bonds can bring a lower% return, but (and we indicated this in the merits) this is a guaranteed income with clearly defined time metrics of receipt, unlike stocks. There is a known coupon rate for bonds, there is a known payment schedule.
Risks
The risks of bonds can be related to both the economic environment and the parameters of the paper itself or the indicators of the issuer that issued them.
Inflation
With its growth, the value of old bond issues decreases, and the coupon size ceases to cover inflation. As a result, their main advantage over bank deposits is lost.
Market
The size of the coupon and the price of the bonds directly depend on the Central Bank's key rate. First, the key rate in the economy sets the coupon yield of bond issues. Secondly, it determines the movement of the value of bonds. When the rate rises, old bond issues (issued before the rate increase) become cheaper. And bond issues with a long circulation period are particularly sensitive to changes in rates.
Read more: Hyperinflation: the concept, risks and consequences for the economy
Bankruptcy/default of the issuer
This happens if the issuer is unreliable. In the case of government and municipal bonds, the risk of default is minimal. The greatest risks of default are concentrated in classes of bond issues other than Government bonds and municipal. That is, it is the corporate sector of securities. When assessing the reliability of a bond, we evaluate the issuing company. Unreliable can be considered a company that has a high creditworthiness, operates at a loss (or with a minimum profitability lower than the risk-free rate), with a falling revenue indicator. For such companies, there are high risks of non-fulfillment of obligations to investors. But all of these risks have a well-known nature and investors have developed a lot of ways to work with them. There are special strategies for choosing bonds at different phases of the economic cycle (a rising rate or a falling rate), there are bonds in which there is protection against inflation and others.
Liquidity
This is an opportunity for the fastest sale of an asset. The bond market itself is less liquid compared to stocks. But this is due to the fact that bonds are a protective tool. And often bonds are bought for the purpose of holding to maturity. But in the case of stocks, not only investors focused on the long-term effect of the growth of the exchange rate value of shares work, but also speculators (traders) who make a large number of transactions per day, including with the same stock. If we look at the stock market for bonds, we will not see much movement there. Therefore, the low liquidity of bonds can be considered not a disadvantage, but a feature of this instrument.
Benefits of investing in bonds
- Option 1. Deposit. This is the simplest and, unfortunately, the favorite option for placing funds among the majority of the country's population. Arguments – the deposit is more reliable, clearer, it's simple.
- Option 2. A portfolio of bonds. Let's choose some of the most reliable bonds here – we'll set the "blue chips" filter. Government bonds, municipal and corporate "blue chips" fall into this sample. At the same time, we will ask that these are bonds with terms up to two years.
- Option 3. A portfolio of shares. We use a dividend strategy. This method of investing exceeds the previous one in potential, but the risks are also higher here, besides, they are not guaranteed and are not tied to deadlines in any way.
- Option 4. A portfolio of stocks and bonds. We combine the 2 previous portfolios and balance them so as to offset the risks of investing and thereby protect our portfolio. As a result, we get a portfolio less profitable than a portfolio of stocks, but more profitable than just bonds. At the same time, the portfolio risks are almost completely covered.
Read more: What is a Bond: types, risks, difference from stock, pros and cons
Conclusion
Opinions about investments in bonds are radically different. There are investors who believe that if you enter the stock market, then only for investing in stocks, the deposit is easier than bonds (you do not need to choose securities, make transactions, monitor the account, etc.). Others prefer bonds as an excellent alternative to deposits, valuing them for high liquidity (you can sell securities and withdraw funds from the account without losing the interest – coupons paid), the possibility of implementing a variety of strategies (pension, inflation protection, even speculative, etc.). And there is a third category of investors who fill their investment portfolios with stocks and bonds, adjusting the share of the latter in such a way as to be calm in case of possible market drawdowns on stocks.