Investing in bonds carries less risk than investing in shares. Yet there are still risks involved. The return is also more secure, though that also means it may not be as high as that provided by shares.
What are bonds?
Bonds are generally issued by companies or banks. Governments also often issue them, but government bonds are slightly different to corporate bonds.
Essentially, as an investor you are lending money to the company, who gives you an "IOU" in return. This confirms that the company has borrowed money from you, and constitutes the bond itself.
At the start of the investment you are given a fixed annual due date, a final due date and an agreed annual yield. It is this that forms the primary difference between bonds and shares.
The difference between bonds and shares
Shares are something you buy, and they actually represent a part of the company. You thus buy into the company. With bonds, you make a loan to the company. Shares also have no annual maturity date or final maturity date. You therefore only get back your investment and return once you sell the shares on.
However, shares can also provide an annual income in the form of dividends. This happens whenever a company decides to distribute a share of its profits to its shareholders. Whereas bonds guarantee you an annual return, with shares your chance of receiving anything depends on the company management.
Last of all, volatility is also a major point of difference. Shares react more strongly to changes on the stock exchange. This can be both positive and negative. You will experience less volatility with unexpired bonds because the return is generally guaranteed.
Perhaps the biggest reason to choose bonds is their fixed return. With the majority of bonds, when you buy them you know in advance how much you will receive in the form of interest payments. However, there are a number of exceptions to this in the form of bonds that lack any fixed return. Bonds of this kind will have a variable return that is linked to an index or an interest rate indicator.
Capitalisation is possible
One common form of bond is one with capitalisation. This means that the annual return is added directly to the principal of the bond, without you having to do anything yourself. It could therefore be said that bonds require less attention and monitoring than shares.
Ideal for diversifying your portfolio
Investors choose bonds not only for their extra security, but also in order to diversify their portfolios. A golden rule of investing is that you shouldn't bet all your money on one horse. Bonds are an essential part of a healthy mix.
This is primarily because bonds generally take the opposite course to shares. Are shares strongly dropping in value? If so, bonds will typically increase in price, and vice versa.
There are also disadvantages and risks
Credit risk: issuer bankruptcy
The issuer is the company you lend your money to in return for a bond. What if that company goes bankrupt? In that case, you will be close to the bottom of a long list of creditors (although you will still come ahead of any shareholders), making it difficult to recover your investment.
A bond might be listed on a regulated market, but that listing does not guarantee that an active market will develop to allow it to be traded. The liquidity of a bond is often ensured by a professional counterparty that acts as a buyer or – if necessary – as a seller.
Any investor wishing to sell on their bonds before their final due date will have to sell or buy them at the price specified by the professional counterparty. This will depend on the market parameters at that time, which may result in a price that is lower than the original purchase price.
Exchange rate risk
Bonds are also offered for sale in foreign currencies, and you should take this factor into account when buying. The exchange rate between different currencies can be very volatile, and this can make a big difference when you choose to buy or sell your bonds.
There are always risks of a general nature involved when it comes to investing. Interest rates and exchange rates can change rapidly. Nor are companies and bond issuers protected against every possible surprise that the markets might throw at them. All forms of investment therefore involve a certain degree of risk.
A company may opt to pay back your bonds early. You will then receive your initial capital together with the accumulated interest. Not bad, you might think: you have your initial capital and your profit. It looks like the best solution is simply to reinvest. But watch out: the right to early repayment generally results in a slightly higher coupon.
This is only sometimes the case. But it may be that interest rates drop after you buy your first bonds. Imagine that a few years ago you received a guarantee of 10% per year for 10 years. This would result in your money more or less doubling. After 6 years, the company decides to pay you back early and you can now only find bonds offering 4%. This will ultimately lead to a significant difference.