Investing we like to do, in stocks, ETFs and real estate. But investing in bonds can also be a great addition to your investment portfolio. It is said – the gurus in this world – that ideally you should invest your age in bonds. So suppose you are 30 years old, you should put 30% of your invested assets in bonds. Why that is, we are going to explain to you: what exactly are bonds, and how can you invest in them?
What are bonds?
Bonds are loans you make to a company or a government. You lend money, for a certain period of time, and each year you get the pre-agreed interest on the amount lent, also called coupon. The company (or government) issuing the bonds often aims to raise funds temporarily. When the term of the loan is over, you get your entire deposit back. The longer the loan runs, the higher generally the interest rate, because you are spending your money longer and want a higher reward for it. Another security aspect is that the chances of a state like the Netherlands or Germany going bankrupt are virtually nil.
Do you also want to learn what investing in stocks means? Read that this article!
Government bonds
Government bonds are generally seen as less risky. After all, governments are very large and almost always manage to repay their debts in full. Especially with large, stable economies such as those of Germany or the United States, the risk of not receiving your money back is low.
Government bonds have little correlation with equities. Sometimes there is even an opposite relationship. When stock prices do well, government bond prices do not fare as well.
Corporate bonds
Corporate bonds are riskier than government bonds, but tend to perform somewhat better in the long run (higher returns). They also correlate more strongly with stock markets. When the economy is doing badly, corporate bond prices fall. When stock prices do well, corporate bond prices actually rise. This is because with corporate bonds, people are more concerned about whether or not they will be repaid. After all, corporations fail more often than governments.
Low risk
A bond is considered a low-risk investment because companies and governments to whom you lend money are generally quite stable. Should a company go bankrupt, bondholders are first in line to get their pennies back. Only after that will it be the shareholders’ turn. And the chances of a state like the Netherlands or Germany going bankrupt are low. Bonds are therefore a somewhat safer investment than stocks. After all, you know in advance where you stand. The coupon rate and the end date of the bond are fixed so you know exactly how much return you will make. Note that investing remains a risk, even in bonds!
You can earn price returns in addition to the direct return as the market value of your bond rises. Also, once interest rates fall, bond prices will rise. And interest rates have been continuously adjusted downward by the European Central Bank (ECB) in recent months.
Coupon
You lend money, for a certain period of time, and each year you get the pre-agreed interest on the amount lent, also called coupon. The purpose of issuing bonds is often to raise financial resources. When the term of the loan is over, you also get your entire deposit back. Buying a bond is considered a low-risk investment because companies and governments to whom you lend money are generally quite stable.
Example
Suppose you buy a bond of €1000, and the coupon (interest rate) is 5%. The bond is fixed for 10 years. That means you lend €1000 for 10 years, after 10 years you get your loan back. Meanwhile, every year you get 5% interest on your loaned money, so every year you get €50. So after 10 years, you will have earned 10 x €50 = €500 on this loan. After 10 years you get the €1000 back, so your investment has brought you €500.
What determines the price of bonds?
The market interest rate (set by the ECB, or another major bank) has the greatest influence on the price of a bond. The interest rate on a bond is fixed. If you bought a 30-year bond with an 8% interest rate some time ago, you will always receive this eight percent. However, the European Bank regularly adjusts interest rates to stimulate the economy.
When interest rates fall and you have a bond with a higher interest rate than that of the market then the value of the bond will rise. This is because the return on your bond relative to the return on a savings account increases.
On the contrary, rising interest rates will have a negative impact on the value of a bond. As market interest rates rise, interest in your bond will decrease, causing the price to fall.
Creditworthiness
Important to know should you want to buy bonds: keep in mind the so-called credit rating. A label has been developed for this and creditworthiness is indicated by letters. If a bond has an AAA, AA, A or BBB label then it is a relatively low-risk bond. For example, Dutch or German government bonds: the probability of these states going bankrupt is very small. All bonds below label BBB are considered risky(er).
Although the interest rate on your bond is fixed, the value of your bond can change over time. So bonds are also volatile, but less so than stocks. Supply and demand, European Central Bank policy and interest rates largely influence bond prices.
If you hold a bond until it matures, you know you’ll get your deposit back. But if you sell a bond before its maturity, then you have to deal with the price at that time. It may be lower or higher than when you started. Similarly, when you buy and sell bonds, you can make a loss or a profit.
Why do companies sometimes issue bonds when you can also buy stocks?
Sometimes you hear from companies that they are going to issue bonds. Companies that are also publicly traded and thus one can buy shares in. So why does a company issue bonds? There could be several reasons for this. At its core, what happens when shares are issued is that companies allow other people to take a little bit of co-ownership of the company. If you buy stock that’s investing money in the company, in exchange for co-ownership, and hopefully in exchange for future profits. In fact, when companies go public they do so to raise money and investment.
But sometimes companies choose not to issue additional shares, but to issue bonds. This is also a way to attract money. A company may choose to issue bonds simply because they may not be publicly traded and do not want to borrow money from banks. Or they are listed but don’t want more shareholders.
A state, such as the Netherlands or Germany, can only raise money by issuing bonds. Because states cannot issue shares, simply because no one can co-own a country.
How can you invest in bonds?
Okay, all well and good, but how can you invest in bonds? If you have a lot of money then the bank can help you buy government bonds. In addition, you can also buy (parts of) a bond at DEGIRO. You can also invest in bond ETFs. So that’s a basket of different bonds. An example of a bond tracker is:
Xtrackers II Global Government Bond UCITS ETF 5C. This tracker tracks global government bonds.
Or:
Xtrackers II ESG EUR Corporate Bond UCITS ETF 1C, it tracks bonds of large European companies.
Through parties such as Peaks or Brand New Day, you can invest in funds where you specify what percentage of your money you want to invest in bonds through your stated risk profile. This is the easiest way to include bonds in your portfolio, if you ask us.
When is investing in bonds right for you?
Investing in bonds is a suitable option if you are fine with some risk, but want to limit that risk a bit. Because the term and coupon rate are fixed, you have clarity in advance about what this investment will pay you. Many investors choose to invest a portion of their assets in bonds. A common saying is that you should have the same percentage of bonds in your investment portfolio as your age. The older you get, the more bonds, so you are less and less at risk with your money.
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