In case you are not a big stocks fan, you could always go for bonds. The latter is less volatile and more secure so many investors prefer them. In this article, you will learn more about the important aspects of this type of investment.
Where to start
It might seem like a tricky task at first since there is a required initial investment. Most bonds have a face value of $1,000, but there are some tricks to avoid that. You can purchase from:
- A broker: There are many online platforms to choose from. Here you will be looking for another individual who is selling. If you decide to purchase directly from the investment bank, you could also take advantage of a certain discount.
- ETFs: they usually purchase bonds of different firms and there is a variety to choose from, depending on your strategy. Using ETFs you immediately diversify your portfolio and you remove the need to get increments of a thousand dollars.
- the U.S. government: you can visit the Treasury Direct site in order to buy government bonds, without any fees and middlemen.
Be cautious about those things
1. CAN THE BORROWER PAY ITS BONDS?
It is very important to consider this point. In case the answer is no, then this means that the investor should not consider purchasing them. You can check the rating of the bond, which shows their creditworthiness. The AAA rating is the highest and it could decrease like a school grade. The better the rating, the bigger the chance of the company paying their obligations and the lower the interest rate for you.
The easiest way to determine the state of a firm is by checking the ratio between the interest rate it is paying and its income. If it is struggling and the income is barely covering it, then it is a risky choice. Every publicly traded corporation uploads this information on its website. To calculate it you have to take the operating income and divide it by the interest expense. If the result is:
- 4 or over: There shouldn’t be any problem with the firm meeting the obligations.
- between 2.5 and 4: The firm is in good shape, but if it’s close to 2.5 you should be careful.
- between 1 and 2.5: The firm may experience some trouble covering the debt.
- Below 1: The firm will experience problems..
Look at a couple of years and calculate. In this way you will get a broader picture.
Government bonds. It’s a little bit different with government bonds since you won’t be able to find excess revenue which could usually show stability. It’s good that they are as a whole more secure (the USA one is with rating AAA).
Municipal bonds. Those bonds are issued by the municipalities, and although they could be considered secure, there have been some instances in history when that wasn’t the case. Research carefully beforehand the financial statements, disclosures and the official prospectus.
2. WHEN SHOULD I BUY?
When you know the interest rate you will enter the debt market. Afterwards you will notice that the price of the bonds moves, depending on the interest rate. The fluctuations are countercyclical. A beginner might think that the best time to purchase is when the value is really low, however, it is more complicated than that. You should know that interest rates also experience long-term changes. Many investors make predictions regarding their fluctuations. However, this could lead to delays in purchases which is not a good idea for beginners. To minimize risk, many decide to purchase many bonds which will mature after years and in this way create a “ladder” effect. After one bond matures, there is reinvestment and the ladder becomes bigger and bigger. In this way investors diversify their portfolio and minimize risks.
3. WHICH BONDS TO CHOOSE?
Before picking a particular bond to invest in you should think about your risk tolerance, income requirements and tax situation.
Some of the typer going from less to more risky are:
- Federal government bonds. Those are the most secure ones and their interest rate is low. There are also “zero-coupon bonds” which are with discounts. You will not receive cash once they are mature.
- Municipal bonds. They are issued by the state and local governments and are among the lowest-yielding bonds. However, it is important to know that they are non-taxable.
- Investment-grade corporate bonds. They are issued by companies with good credit ratings. They come with low-interest rates because they are more secure.
- High-yield bonds. Also called junk bonds. They give larger payout than typical investment-grade bonds because of how risky they are..