Bonds are a popular investment option, and many people choose to buy them because they are easy to trade, even if you’re not an experienced investor. This guide explains the basics of bonds and how to start trading them successfully.
What are bonds?
Bonds can be viewed from two perspectives: the issuer’s perspective and the investor’s perspective.
You are the investor, and the issuer issues bonds as a tool to raise funds; they are financial instruments that accumulate interest.
Private entities or governments can issue bonds to fund new projects to supplement revenues. By buying a bond, you are lending the issuer money as a loan repayable with interest over a specified period.
Here are some of the terms used in bond trading. These definitions will help you understand bond trading better.
Bond terminologies
While beginners may think that bond terminology is literal and straightforward, it can be confusing. Here’s what the popular bond terminologies mean:
- Price: Like every other market commodity, bonds have a price. However, the issuer’s asking price and the investor’s bid price determine the price. Bond prices can be tracked on trading platforms. The asking price is the cheapest the issuer offers, but the bid price is the highest amount of money an investor is willing to pay for a bond.
- Maturity: This is the agreed date on which the bond issuer will return the principal invested to the bond investors. Bond maturity can be classified as short, medium, or long-term, depending on the duration of the loan. Short-term maturity is generally below four years, medium-term maturity is between four and ten years, and long-term maturity runs over ten years.
- Face value: Another term for face value is par. Face value or par refers to the monetary value of a bond upon maturity. This determines how much the bond issuer will pay the investor as interest.
- Coupon: This term refers to the interest rate the bond issuer periodically pays the investor. Another term for Coupon is nominal yield.
- Yield: This is the rate of return the bond issuer will pay the investor. Contrary to the fixed price of the Coupon, yield is more flexible as it depends on external factors like the secondary market and inflation. As current yield, yield to maturity, or yield to call, yield considers the bond’s fluctuating value over the specified period.
Types of bonds
Bonds are classified based on price, tax treatments, and how they are traded in the market. They include:
Corporate bonds
Corporate bonds are debt securities issued by private or public entities to raise funds. Interest on these bonds is subject to local and federal income taxes. The yield is often subject to the credibility of the entity.
Sovereign or government bonds
As the name implies, these are debt securities issued by federal governments to offset some expenditures. Since top governments issue these bonds, they have meagre yields and only have to cover federal income tax as they are exempt from state and local taxes.
Agency bonds
These are bonds issued by government-sponsored enterprises to cover the cost of things like education, housing, and other lending initiatives. Like sovereign bonds, agency bonds are often only subject to federal tax.
Municipal bonds
Like government bonds, municipal bonds can be issued by states, cities, and counties to fund local projects. They are about the best bond any investor can buy, as they are federal and state tax-free.
Are bonds different from stocks?
Stocks and bonds are trendy investment options, but they are often mistaken as the same. However, there are a few differences between these investment options. These differences include:
Ownership: With stocks, investors own a stake in the issuer’s profits or losses; on the other hand, bonds do not offer investors ownership rights. Hence, bond investors will not gain or lose from the issuer’s profit.
Terms of Agreement: Unlike stocks, where investors simply wait to see how things pan out, bonds are issued on defined and legally binding agreement terms. These agreements state the duties and responsibilities of both parties, which they must fulfil.
Risk: Bonds are safer than stocks because they’re debt security. Regardless of the project outcome for which the loan was needed, the entity must pay the stipulated Coupon and yield to investors at maturity.
How can you invest in bonds?
Investing in bonds is straightforward when you use a reputable broker. Many brokers offer bond access through initial bond offerings and the secondary market. However, not all brokers allow you to buy bonds directly, so choosing a trustworthy broker is essential. This is where trading platforms like TradingView come in handy to connect you with professional brokers.
A reliable broker will provide access to various bonds and ensure you receive your interest payments and the bond’s face value when it matures. Keep in mind that bond values can fluctuate after issuance.
If you hold the bond until maturity, your interest payments and face value will remain consistent. Selling the bond before maturity may result in a price different from its face value.
Factors to consider before investing in bonds
No two bonds are exactly alike; that’s why it’s crucial for beginners to consider the following:
Interest rate: The bond’s interest rate, also known as the coupon rate, determines your annual interest payments. Compare this rate to current market rates to ensure you’re getting a competitive return on your investment.
Credit rating: The issuer’s credit rating reflects their ability to repay the bond’s principal and interest. A higher credit rating indicates lower risk but may offer a lower interest rate.
Maturity date: Choose a date that aligns with your financial goals and investment timeline.
Yield: A bond’s yield considers its interest payments, price, and maturity date to measure its overall return. Calculate the yield to understand the returns better and compare your options.
Fees and costs: Be aware of any fees or costs associated with buying, selling, or holding the bond. These can include brokerage fees, transaction costs, and management fees. Minimising these costs can help improve your overall investment returns.
Tax implications: Some bonds offer tax advantages, such as municipal bonds that are often tax-exempt at the federal or state level, making them more tax-efficient investment options.
Why choose bond trading for beginners?
Bond trading offers a relatively safe and accessible investment avenue for beginners, providing opportunities to diversify portfolios and earn consistent returns through interest payments. While bonds generally present lower risks compared to stocks, it’s essential to carefully consider factors like interest rates, credit ratings, maturity dates, yields, fees, and tax implications before investing.
The above information does not constitute any form of advice or recommendation by London Loves Business and is not intended to be relied upon by users in making (or refraining from making) any finance decisions. Appropriate independent advice should be obtained before making any such decision. London Loves Business bears no responsibility for any gains or losses.
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