Getting Started in Bonds
Bonds are generally regarded as safe, low risk investments with guaranteed returns. However, the experience with Greece and Spain and the numerous near-defaults of the government of Greece in repaying bond holders has shown that even with government bonds that are supposed to have the safest profile, you can never really be too sure of a bond investment. There are many issues that must be considered, and the aim of this article is to show you how to get started as a bond investor.
So how can an investor get started in bonds? To get started in bonds, the following issues need to be considered
a) How to choose an investment professional and a broker/issuing house.
b) Investment modalities
c) Bond trading strategies
d) Special considerations.
How to Choose a Broker/Investment Professional
This is the starting point of your bond investing career. Unlike forex trading or other trading types, bond investing is not an endeavour that you should get into alone. It is best to use a financial advisor who clearly understands the issues pertaining to bond investment. You will need to choose a broker. There are two types of brokers that are available for bond trading. The full service brokers are better suited for institutional and high net-worth investors, as their services come at a premium which may not be available for individual investors. Full service brokers provide ‘full services’ ranging from investment advice to active portfolio management and personalized services. Individual investors can use the discount brokerage firms that do not provide most of the services that full-service brokers offer. There is also the option of using an online brokerage firm.
In choosing a broker, you need to choose one whose interests will not compete with yours. You need to know if you can get access to the kind of bonds you want through your broker. You need to know how much you are paying in fees. Above all, you also need to make sure that the broker you are using is licensed to deal in the bonds market. Beware of third-party brokers. They are basically marketers and going through them will increase your fees as you will bear the cost of their compensation.
When choosing a financial advisor to work with, such a person must be licensed as such and must be able to show you a track record of performance with other clients.
Investment Modalities/Bond Buying Considerations
When you have got a suitable broker, the next step is deciding how to invest in the bond market. This is where you answer the following questions:
a) What kind of bonds should I buy for my risk profile? Those who want to take some bigger risk can decide to invest in higher-yielding bonds, or bonds that are assembled as a mixed portfolio.
b) How much money do I have to invest? This point will determine where to piut your money as many bonds have minimum investment amounts attached.
c) How long can I afford the bond investment? Can I afford to keep my money in a 10 –year bond, or would I need to use some money in 5 years? Generally, those who have plenty of free cash or are looking for a safer way to keep away money for the long term can decide to buy bonds with longer maturity dates.
d) A very important consideration would be to consider your age and how many years of working life you have left. Those closer to retirement should not trade bonds with higher risk.
In essence, the answers to these questions would determine your investment goals, and this would serve as a guide for your bond investments.
When investing in bonds, you can buy the following forms of bonds:
a) Individual bonds
b) Bond unit trusts: These are trusts in which a mixed portfolio of different types of bonds are assembled into a single investment vehicle.
c) Money market bonds which are actually investments in short term securities that have been pooled together into individual bond investment portfolios. Maturities are much shorter (about three months) and the bonds are highly liquid, allowing traders to cash out easily.
Bond Trading Strategies
For most bond investors who move into bonds because of the relative safety of this investment vehicle, the essence of bond trading is first to preserve capital, and then to get interest payments. To achieve this, the bond would have to be held to maturity. The maturity period chosen will depend on the investor’s goals. Buying and holding a bond until maturity is a strategy that must be deployed carefully. For instance, if the bond investor has invested in several bonds, it is better to create a portfolio where each bond has a different maturity. Such “laddered” portfolios should consist of a bond maturity for the long term (10 years) and probably one or two short term and medium term maturities (one year or five years). That way, the principal becomes available for re-investment. If at the time of the re-investment, the government has raised interest rates to combat inflation, then any bond investment done at this time will bring in higher interest yields. This style of investing in bond with short, medium and long term maturities is known as a ladder investment. Another type of a buy and hold bond investment strategy involves using only long term and short term maturities. This is known as the barbell strategy.
For investors who are not interested in the buy and hold strategy, there are certain bonds which are “callable”, i.e. which can be sold before maturity. However, interest yields on the bond are typically lower.
When investing in bonds, the following special considerations must be brought to play to protect the investment as much as possible.
a) Diversify bond investments. A diversified bond investment spreads out the risk. You can choose a bond from different issuers, or bonds in different asset classes, or use a ladder/barbell investment model.
b) Always investigate the credit-worthiness of the issuer to avoid risk of default.
c) Take note of the yield-to-maturity and yield-to-call rates.
Bond investing will work for you if you stick to what has been discussed in this piece.