What are bonds, and how can you as an investor make money from this? And when can bonds be a good investment? In this article you will get the answer to all these questions.
Bonds are actually not that difficult to get to grips with, and are not as complicated as you might think.
By and large, it is about the fact that institutions such as states and large companies also have a need to borrow money. Here you can support them by lending them money, and you earn money back on an agreed interest rate in the bond.
Here you will learn everything you need to know about bonds and bond funds, so that you can make a decision on whether this is something that suits your investment strategy.
So, let's get started!
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What are bonds?
A bond is proof that you have lent money, often to large institutions, municipalities, states or large companies. A bond is a promissory note that defines an agreed interest rate that you, as the lender, are entitled to.
The bond states how much interest must be paid to you for the loan you have given them, as well as when the loan falls due.
Bonds are a very efficient way for large institutions to borrow money from several different creditors (you and others) at once.
As a general rule, the yield for longer bonds is higher.
Investing in bonds
You can buy individual bonds or buy a bond fund. What you then do as an investor is lend money to the issuer in return for an agreed interest rate.
Bond fund
A bond fund is an interest fund that invests in long-term bonds.
If you are looking for a higher return than you get in your savings account, with lower risk than individual bonds and shares, a bond fund may be worth looking into.
The bond fund's duration (maturity) varies. Some have shorter maturities, and have a lower risk of interest rate changes than bond funds with longer maturities.
Your return therefore has the highest potential if you have bonds with a long duration. In return, the risk is also higher than bonds with a short maturity.
Different types of bonds
There are various types of bonds with national or foreign issuers. The two most common are government bonds and corporate bonds.
Government bonds
Government bonds are the safest form of bonds, as the issuer is the government. The bond is thus also guaranteed by the state. Keep in mind here that your expected return will not be among the highest with such bonds - simply because they are considered very safe.
Corporate bonds
You also have corporate bonds, or credit bonds.
These bonds are issued by a company, not the government. This could be, for example, companies in sectors such as banking, property and so on.
In this case, it is the company itself that guarantees the bonds, and the risk can thus be higher, as the company's financial health and credit quality play an important role.
The value of bonds can fluctuate depending on the bond's duration and credit quality. You can expect higher returns on corporate bonds than you can on government bonds. This is because the companies often offer a higher interest rate as you, as a lender, have to take account of higher credit risk.
Bond funds usually have a target length, for example five to ten years.
Advantages of bonds
Lower risk
A major and important advantage of bonds is that you take lower risk than investments in stocks.
The government, the bank or the company to which you lend your money promises to pay you back, in addition to what you earn from the interest - regardless of whether they themselves should make a profit or loss.
If the borrower goes bankrupt, you as a creditor are also first in the queue - ahead of the shareholders - when it comes to getting your money back.
You don't have to pay attention
Once you've loaned out your money, there's not much to do but find something else to do.
The investment takes care of itself, and you don't have to follow share prices or worry about the market fluctuating.
Higher return than a savings account
Bond funds give you an expected higher return than savings in a bank account.
Stable
Bonds give you stability if, for example, you have a combination fund (a fund that contains both shares and bonds).
Hedge against deflation
Bonds can provide you with good protection against deflation in times of crisis.
Get started with investing at Nordnet
I recommend Nordnet because of their large selection of shares and funds, low fees, good learning resources + free access to the share forum Shareville (ad).
Disadvantages of bonds
But there are also things about bonds that you have to take into account:
Fees
Fees can eat into returns, so be sure to check how high the bond fund's fees are. You can find this by reading the information about the fund.
Credit risk
Credit risk is basically bankruptcy risk.
As you now know, you get a higher return on bonds issued by companies than if you lend money to the state and municipality. But then you also assume the risk that the company may go bankrupt, and that you will therefore not get back the money you have lent.
Interest rate risk
Interest rate risk says something about how sensitive the return is to changes in the general level of interest rates in the market.
The longer the duration, the higher the interest rate risk. And the longer the time left until the bonds that the fund sits on expire, the greater the price fluctuation in the fund if the interest rate changes.
If the general market interest rate rises, the value of a bond fund will fall, while with falling interest rates the value will rise.
Why? Because the funds own the interest-bearing securities with a fixed agreed interest rate. If the market interest rate rises, the difference between the fund's fixed interest rate and the market interest rate will therefore be greater, which makes the fund look less attractive. If, on the other hand, the market interest rate falls, the difference can look more positive for the bond fund.
What do the great investors think about bonds?
Big investors like Warren Buffett are known to prefer stocks over bonds. That doesn't mean he doesn't see value in bonds, but he definitely sees stocks as a more favorable investment for high, long-term returns.
Buffett has previously stated that he believes the vast majority of investors should stick to a 90/10 model:
- 90 percent in global index funds (equity funds)
- 10 percent in short-term government bonds
In the video above, you can see why Buffett prefers stocks over bonds.
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So, invest in bonds or stocks?
I agree with Buffett that shares are a better investment for high long-term returns. According to this Motley Fool article stocks have outperformed bonds by 20 percent from 1987 (Black Monday) to today.
But it depends on you doing it right and doing your homework when analysing stocks.
We are not talking about daytrading here, but long-term investment in the stock market. Buy big, boring companies and hold them for 10-20 years +.
And don't you want to own individual shares? Then you can, for example, buy a global index fund, create fixed monthly savings and forget about it.
Check, for example, Nordnet's good selection of index funds with low fees.
- Nordnet Global indeks 125
- DNB Global Indeks A (my favorite)
