You Can Lose Money Investing in Bonds
With bonds (also called "bonds", "annuities" or "fixed-income securities") states or companies borrow money from investors for a predetermined period of time. The issuer of a bond pays interest on the borrowed capital once a year. At the end of the term, he has to repay the borrowed money to the investors. Continue reading
Opportunities & Benefits of Bonds
Bonds are traded as a percentage of the nominal amount. You do not buy a certain number of shares as you do with a share, but invest a nominal amount - regardless of whether you buy government bonds, federal bonds or corporate bonds.
If you find and buy a bond that suits you, you are entitled to repayment of the nominal value as well as interest (nominal interest = "coupon"), which is usually paid annually. The amount of interest on bonds depends on the debtor's creditworthiness and the term of the bond.
The lower the credit rating and the longer the term, the higher the nominal interest rate. In the case of fixed-income securities, the interest rate remains constant during the term. In the case of securities with variable interest rates ("floaters"), it is adjusted regularly.
Government bonds from solid countries usually have a lower interest rate than corporate bonds because government bonds (such as federal bonds from the Federal Republic of Germany) have a lower risk of default than corporate bonds.
Suitability for asset accumulation
Depending on the interest rate and risk, bonds are well suited for long-term wealth accumulation. It is crucial that you find the right bonds for your investment goals. Ask an experienced financial advisor or investment advisor about this.
Unlike stocks, most bonds fluctuate significantly less in price and typically provide a reliable return. They are therefore considered to be a comparatively safe system. This is especially true for government bonds from economically strong countries.
In order to build up your assets, however, it is also important for bonds not to invest large parts of the savings or assets in just one bond, but to distribute it over several securities.
As an asset class, bonds are very transparent and easy to understand. It gets more complicated when you take a look at the respective issuer. After all, it depends on his financial strength how secure the bond is.
With quite a few issuers, especially with smaller, unlisted companies, the financial situation is difficult to assess. With regard to their key financial figures, they are not obliged to provide information to the same extent as stock corporations listed on the stock exchange. That makes bonds from these companies risky.
Rating agencies, which assess the creditworthiness of states and companies and help to find the bonds suitable for one's own investment goals, offer assistance.
But: Not all issuers submit to the judgment of rating agencies. There are quite a few fixed-income securities for which there is no credit rating. In such a case, be sure to ask a competent financial advisor for his assessment.
If the issuer of a bond defaults on payment, interest payments may be suspended. In the event of the issuer's insolvency, there is even a risk of losing at least part of the capital.
The price of a bond depends on the respective market interest rate and can fluctuate accordingly. If you want to sell the bond before the end of the term and the price is below the nominal value, you can incur losses.
If you buy government bonds or corporate bonds that are not based in the euro zone, there is an exchange rate risk. If the exchange rate against the euro has fallen when the paid-up capital is repaid or the bond is sold prematurely, you will incur losses.
The term of bonds is often between two and ten years. However, some bonds can also have significantly longer terms.
Cost of bonds
As with stocks, buying bonds incurs a fee to the bank. It is usually between 0.25 and 0.5 percent of the amount invested. Some banks also require fixed amounts of 5 or 10 euros per order.
Sometimes banks also forego a fee, but instead collect the retail prices. That means: You buy from the bank at a slightly worse price than on the stock exchange. The bank collects the difference between the purchase price and the stock exchange price.
In addition, you have to pay fees to the respective exchange on which you purchase the bond. Depending on the trading venue, it is between 2 and 6 euros per order.
Because of the comparatively high costs, it is not worth holding bonds for a short time. Especially with small purchase sums, the fees can quickly eat up the return. Bonds are therefore only suitable for private consumers as a long-term investment.
When investment advisors structure a fortune for their clients, one asset class is almost always part of it: bonds. Whether through direct investments or through investment funds and life insurance - so-called “fixed-income securities” have a safe place in one way or another in the portfolios of millions of investors. WhoFinance explains how bonds work, what you need to pay particular attention to as a private investor and how you can find the right bonds. Continue reading
Hedging with bonds
Bonds have their good reputation because they hedge a portfolio against excessive fluctuations. So you should protect investors from excessive losses.
This means that investment advisors and many professional investors consider them a good addition to stocks that are more prone to fluctuations. Because: stocks or equity funds offer higher potential returns than bonds, but the risks are usually much greater.
Government bonds from high-performing industrialized countries are considered to be particularly secure. Federal bonds, for example, as fixed-income securities of the Federal Republic of Germany are called, are among the safest investments in the world.
Issuer of bonds
In the case of bonds, a distinction is made between government bonds and corporate bonds. In both cases, an issuer borrows money from investors for a predetermined period of time. So he takes out a loan.
This is why bonds are also called “debt securities”. They certify the right to repayment of the money to the investor and the amount of the interest payment (“coupon”).
The amount of the interest depends on the creditworthiness of the debtor and the term of the fixed-income security. It is often between two and ten years. However, government bonds in particular can also have significantly longer terms of up to 100 years in exceptional cases (so-called “century bonds”). They are of particular interest to large insurance companies that think in very long cycles.
Annual interest on bonds
As a rule, the lower the credit rating and the longer the term, the higher the interest rate on a bond. In the case of fixed-income securities, the interest rate remains constant over the entire term. In the case of floating-rate bonds (“floaters”), it is adjusted regularly. The interest on government bonds and corporate bonds is usually paid once a year.
Most bonds trade like stocks in the financial markets. The price when the bond is issued corresponds to the nominal price of 100. However, it can rise or fall during the term.
For you as an investor, this means: If you find and then want to buy a bond that is already on the market and the price is 104, you pay 1040 euros for an investment of 1000 euros for the bond. If, on the other hand, the rate is 95, you only have to pay 950 euros.
Price & yield of bonds
However, the interest on the bond also changes at the same time. When the price of a bond falls, the interest rate increases; if it rises, the interest rate falls. In short: the lower the price of a bond, the higher the yield - and vice versa.
If you want to sell a bond before the end of the term, there may be price losses or gains.
When the term of a bond has expired, however, you will usually get back all of the borrowed capital. So if you buy a bond at an initial price of 100 and hold it until the end of the term, you may not care about the price development in the meantime.
Creditworthiness & solvency of bond issuers
But be careful: if the issuer of a bond goes bankrupt, you could lose part or all of your money. Therefore, you should examine the solvency and creditworthiness of a company or state before buying a bond.
If you want to find suitable bonds for your investment goals, the assessments of rating agencies can help - however, these ratings are only a guide, as you cannot rely 100 percent on the ratings. After all, before the outbreak of the financial market crisis, many securities were rated with the best creditworthiness - and then lost massively in value. This also included fixed-income securities such as Greek government bonds.
In summary: When you buy bonds, you have a price risk (possible losses in the event of an early sale) and an issuer risk (the debtor cannot repay or at least cannot service the interest).
Bonds & stocks
So government bonds and corporate bonds cannot be bought “blindly” either. The example of Greek government bonds, but also many corporate bonds, especially from medium-sized companies, shows that investors can also get a bloody nose with fixed-income securities.
In quite a few cases, some investment advisors and financial advisors consider solid stocks of large corporations, which also pay reliable solid dividends, as an alternative to some government bonds.
However: government bonds from rich industrialized countries such as federal bonds of the Federal Republic of Germany or government bonds (so-called “treasuries”) of the USA are still considered to be a “safe bank” for investors - even though the yields are currently extremely low.
You can buy government bonds or corporate bonds on the stock exchange. To do this, you need a securities account with a bank or an online broker. You pay a fee when you buy and sell fixed income securities. WhoFinance gives tips on how to buy bonds and what to look out for. Continue reading
Denomination of bonds
When finding and buying bonds, pay attention to the denominations. Background: When states or companies issue bonds, they divide the amount they want to collect into several equal amounts. This makes it easier for several investors to participate in the purchase of a bond. This process is called denomination for bonds.
A classic denomination of a bond is, for example, 1000 euros. That means: An investor must take at least 1000 euros in hand to invest in the corresponding fixed-income security.
For bonds, however, there are also denominations of 50,000 euros or 100,000 euros. They are unsuitable for normal private investors due to the high stakes. Bonds in such large denominations are mostly bought by banks, insurance companies and other institutional investors.
Bonds ask price
The ask price is the price at which a bond is offered on the market. The higher the ask price, the more expensive it is for you as an investor to buy the bond.
The easiest way to find the ask prices for bonds is on the websites of the major German bond exchanges in Frankfurt, Stuttgart and Düsseldorf.
Attention: The ask prices of bonds can differ between the individual stock exchanges. If you want to find a suitable bond, you should make sure that you catch the cheap ask price.
Bid-ask spread for bonds
But looking at the ask price of a bond is not enough. You also have to pay attention to the so-called bid-ask spread with bonds. It shows the difference between the buying and selling price of a bond.
The larger the range, the less often a bond is bought and sold. The range should not be more than one percentage point. The reason: If the bid-ask spread is higher, the bond will only be traded a little. A sale before the end of the term could therefore be difficult, as in the worst case you won't find a buyer.
However, the risk is low with bonds from large, financially strong countries, such as federal bonds from the Federal Republic of Germany, and with large companies with good credit ratings. These bonds tend to be very brisk.
When you purchase a bond, not only do you incur stock market fees, but the bank also picks up on the settlement of the purchase of fixed-income securities. You can influence both items: because the individual exchanges charge different fees for bonds as do the custodian banks.
Find out what fees different banks and exchanges charge for buying and selling bonds. Compare the costs. A competent financial advisor or investment advisor can help you with this.
Alternatives to bonds
An alternative to direct investments in bonds are bond funds, which pool the money of numerous investors and invest in various government bonds and / or corporate bonds.
Bond funds and ETFs
When it comes to bond funds, professional fund managers choose bonds. In which countries, regions or sectors (in the case of corporate bonds) the investment is made is specified in the sales prospectus of the relevant bond fund. When you buy a bond fund, you usually have to pay an initial sales charge and an annual management fee.
With index funds or exchange traded funds (ETFs) you can get involved in the bond market passively. That means: You invest money in a bond index and thus in a previously defined bond portfolio.
Passive versus active
The order fee and annual management fee are significantly lower for index funds and ETFs than for bond funds. Because they are not actively managed by a fund manager and reallocated if necessary; rather, index funds or ETFs only show the development of the bonds listed in an index one-to-one.
For decades, European, Japanese and US government bonds in particular had a reputation for being virtually fail-safe. That changed with the outbreak of the sovereign debt crisis in Europe and other regions of the world. At least fixed-income securities from large, strong industrialized countries such as Germany or the USA are still considered to be very conservative and therefore safe investments. WhoFinance explains what you need to know about bond ratings, creditworthiness, and yields. Continue reading
Creditworthiness of bonds
There is a lot for consumers to consider when it comes to bonds. Any good investment adviser will first make you aware of creditworthiness before buying any bonds. The credit rating tells you how solid the state that issues the bonds is. An investor can use this to determine whether he is taking a low, medium or high risk by buying a government bond, and he can compare the opportunities and risks of different bonds with one another.
The lower the risk, the lower the return
As with any financial investment, the following applies to bonds: the lower the risk, the lower the interest. Because there is little return on very secure papers. Investment advisors and financial advisors often recommend government bonds with good credit ratings, such as federal bonds from the Federal Republic of Germany, to their customers. They are a “stable backbone” for the depot.
Correctly assess the creditworthiness of bonds
The creditworthiness of bonds is assessed by professional institutions, so-called rating agencies. You employ experts who continuously analyze and classify the financial situation of states, companies and other institutions on the basis of current figures.
Rating agencies earn money with the fact that many debtors want to have their creditworthiness assessed. They hope this will make it easier for them to convince investors to invest in the bonds they have issued. After all, investors want to have as much information as possible about a security before making an investment.
Investment banks, fund companies, insurance companies, asset managers and investment advisors use the analyzes of the rating agencies. On this basis, among other things, they decide whether they can recommend their customers to invest in government bonds or corporate bonds.
Three major rating agencies have dominated the market for awarding credit ratings for decades: The US companies Moody’s, Standard & Poor’s (S&P) and Fitch. Together they have a market share of more than 90 percent in the global rating market.
There are also a number of smaller agencies that often specialize in bonds from certain regions or certain industries. In Germany, this includes Scope Ratings in Berlin, which are on their way to becoming a European rating agency and have recently also been evaluating European banks.
Credit ratings for bonds
Rating agencies assign grades from A to D for most of the fixed-income securities traded on the market. These grades reflect the so-called “creditworthiness” of the respective debtor.
Best grade "Triple A"
The best ratings for bonds from S&P and Fitch are “AAA”. At the rating agency Moody's, the top rating is "Aaa". In the financial sector, this highest rating is also called “Triple A” (translated as “Triple A”).
Papers rated AAA have a very low risk of failure. These include federal bonds, for example. Bonds with a comparatively high credit rating are often given the term “investment grade” (“suitable as an investment”). These include bonds with high credit quality (“AAA” and “AA”) as well as those with medium credit quality (“A” and “BBB”).
Bonds with junk status
Bonds with a rating lower than “Investment Grade” are labeled “Non Investment Grade”. They include securities with “BB” and “B” as well as speculative bonds (“CCC”, “CC”, “C”). Bonds with the worst credit rating have a rating of C (from Moody's) or D (from S&P and Fitch). As a financial investment, you are at high risk of default. One speaks colloquially of "junk status".
This means that anyone who invests in these bonds must assume that they will not get their money back, or at least not in full. The individual rating terms and their meaning can be found in the following table.
Rating and course
The rating largely determines the price of a bond. Because professional and private investors make the buying and selling of securities dependent on the current rating of a rating agency. Papers whose credit rating is downgraded by one or more of the big three agencies therefore usually lose their value immediately. Conversely, bonds often increase in value as the issuer's credit rating improves.
Investors should consider one thing: the rating of an investment alone is not enough to assess its quality. The credit rating can therefore only be one of several indicators for an investment.
You have to pay attention to this
Even with papers with good and top grades, private investors should always ask themselves critically what can, in the worst case, go wrong with the investment. The financial crisis of the century from 2008 onwards showed that even bonds with top ratings are not immune to downgrades in a crisis-ridden environment.
There is therefore a lot to be said for discussing the pros and cons with people who you trust and who understand something about the matter before making the final decision to buy a bond. Many people discuss important financial decisions with family and friends beforehand. It is also advisable to seek the opinion of investment experts, such as investment advisors or financial advisors.
Bonds come onto the market at a nominal price of exactly 100% and - provided the issuer is reliable - are repaid at a price of 100%. But during the term, the price of bonds, like stocks, can fluctuate. This is particularly relevant for investors who only want to buy fixed-income securities after they have been issued or who want to sell them before the end of their term. WhoFinance explains what influences the price of bonds. Continue reading
The interest rate
Central bank monetary policy has a major impact on bond yields. Because if the key interest rate is raised by the money guards, the yield on government bonds and corporate bonds often also rises. On the other hand, the price of bonds that are already running is falling.
Correspondingly, bond prices are often also dependent on economic expectations: when the economy is booming, they usually fall. Because the markets then tend to expect a tighter monetary policy from the central bank with higher interest rates.
The stock exchange
Bonds are an ideal addition to stocks in any portfolio. When stock prices go down, for example because companies' earnings prospects deteriorate, investors often shift their money into bonds. The result: prices on the bond markets rise, yields fall.
The opposite happens when the business outlook improves. Then many investors get out of bonds again and put more money in stocks. But: Exceptions prove the rule. There are - albeit rarely - phases in which both share prices and bond prices rise or fall at the same time.
The credit rating of bonds
Large rating agencies such as Moody’s, Standard & Poor’s and Fitch regularly assess the solvency or probability of default of states and companies or the bonds they issue and adjust their ratings accordingly.
If the rating for an issuer falls, a bond usually loses value and the yield rises because the risk for investors has increased. The same applies in reverse, of course: if the rating improves, the bond price rises and the yield falls. Because in this case the probability of default of the bond and thus the risk from the point of view of the rating agency has decreased.
As with other securities, there are different types of bonds. As an investor, you should know which variant you are dealing with before buying a fixed-income security. WhoFinance gives an overview and explains what is behind the different bonds.
In the case of convertible bonds, you as the creditor can decide at the end of the term whether you want to exchange your paid-in capital for shares in the company. The exact number of shares and the time of the exchange are already specified when the bond is issued.
Reverse Convertible Bonds
A reverse convertible is actually not a classic bond, but a structured financial product and is therefore identical to certificates. The issuer is usually a bank. In the case of reverse convertibles, it is not you as the creditor who will decide whether you will get your capital back in shares of a certain company at the end of the term, but the debtor. So he has the right to pay his debts with a fixed number of shares.
Often the conditions under which the capital is repaid in shares or in cash are also determined in advance and, for example, made dependent on the price development of the respective share.
In addition to the coupon, these bonds generally contain a kind of risk premium for the bond subscriber.
In the case of structured bonds, the amount of the interest payment depends on the occurrence of certain events. This can be, for example, predetermined growth rates or certain price levels of stock indices.
The scope of the repayment can also be based on such criteria. A special form are zero coupon bonds (also called zero bonds).
In the case of an annuity bond, the issuer does not repay the capital at the end of the term, but rather during the term. In addition to the repayment of the bond, the interest is paid out directly at the same time.
The zero coupon bond / zero bonds
With a zero coupon bond, you do not receive any direct interest payment on the nominal value of 100. Instead, the bond is issued “below par”, i.e. below the nominal value, for example at a price of 95.
At the end of the term, the bond is then withdrawn for 100. The difference is the return for the investor.
Perpetuals / Perpetuities / Konsolbonds
In the case of perpetuals, no repayment is agreed between the issuer and the investor. As an investor, you only receive interest, which is, however, significantly higher than with normal bonds.
The issuer can terminate and redeem the bond prematurely in accordance with the terms of the contract. If you want to get back the capital you have made available, you have to resell the bond to another investor.
The redemption bond
Redemption bonds are very rare. The creditors here do not all get their money back at the end of the term. Rather, the issuer pays back its debts step by step like an installment loan. A lottery procedure decides which lender will be served in a repayment round.
Should I invest in government bonds or corporate bonds in the current market environment? What are the advantages and disadvantages? WhoFinance explains in a brief analysis what you as a private investor should consider before investing in government bonds and corporate bonds. Continue reading
Government bonds are no longer risk-free
Until a few years ago, government bonds were actually one of the safest investments in the world, at least as far as papers from the western industrialized countries and Japan are concerned. But the euro crisis and especially the case of Greece have shown that investors in Europe can also lose a lot of money with fixed-income securities.
Bunds: secure bank with little return
Bonds of the Federal Republic of Germany, so-called federal bonds, are considered to be very secure. However, the return for the investor is correspondingly low. At the moment you hardly get more than 2 percent on the papers.
For comparison: In the ten years before the outbreak of the financial market crisis in 2008, there was an average of 4.2 percent interest on government bonds.
Anyone who invests today in bonds from strong debtors such as the Federal Republic of Germany, Switzerland or the USA threatens to make a real loss with government bonds after deducting inflation.
Bonds from other euro countries: increased risk
For many years, government bonds from other euro countries were actually considered safe investments - until the outbreak of the sovereign debt crisis in southern Europe.
From 2010 onwards, the markets massively lost confidence in Greek government bonds and subsequently also in fixed-income securities issued by Italy, Spain and Portugal. On the other hand, the interest rates on the government bonds of these countries rose in some cases well above the 10 percent mark. In other words, investors were only willing to invest money in these bonds if they received a very high risk premium.
In the case of Greece, the “worst case” scenario occurred at the end: the holders of government bonds in the country had to forego more than 60 percent of their money in the end. Anyone who has other southern European government bonds in their portfolio had to at least tremble about the full repayment of their capital.
Another prominent example of capital loss due to government bonds is Argentina. The country suspended debt servicing in 2002 and offered its creditors to repay only a third of the debt. Many German private investors who had invested in Argentine government bonds were also affected at the time.
Corporate bonds are sometimes safer than government bonds
With a corporate bond, companies raise capital from institutional or private investors. The alternative to this is the classic bank loan. Many companies now use both instruments to raise money for investments, for example.
Bonds give companies more independence
In recent years, however, the market for corporate bonds in Europe has grown rapidly, as many companies want to become less dependent on banks in their financing.
Of course, companies can also raise capital by issuing shares. However, they give up part of their entrepreneurial freedom, since shareholders are co-owners. Those who buy a bond, on the other hand, have no say in the company, but only the right to repayment of the capital plus interest.
Higher yield with many corporate bonds
What are the advantages of corporate bonds?
It's simple: you often get a higher interest rate on corporate bonds than on government bonds. This is a result of the higher risk for the investor, since companies are much more likely to become insolvent in an economic crisis or as a result of a failed business policy.
However, this does not have to be the case in every case. For example, a bond from BASF or Coca Cola has been a much safer investment in recent years than bonds from Greece or some “tiger states” in Asia.
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