In this article you will find out more about bond investments:
Bond investing: Depending on the their individual risk appetite, investors might decide to add bonds as fixed income component to their portfolio allocation. But what is the better fixed income investment: single bonds or rather a bond ETF?
What Are Bonds or Fixed Income
A bond is a debt security which is also called fixed income. Governments, municipalities or corporations (borrowers) issue bonds to raise money from investors willing to lend them money for a certain amount of time against interest payments (e.g., coupon). The interest rate of a bond depends mainly on the borrowers credit rating (the better the lower), duration of the bond and the current interest level determined by the national banks.
Bonds are seen as a less risky investment compared to stocks and are often used by investors to diversify their portfolios and earn a predictable stream of income. The price of a bond can fluctuate, but the interest payments remain fixed, which can make them a more stable investment for those who prioritize stability over growth.
Why to Invest in Bonds
Investing in bonds can offer several advantages, including:
Predictable income: Bonds provide a regular stream of income in the form of interest payments, which can make them a useful tool for investors looking to generate a predictable source of income.
Diversification: Bonds can help to diversify an investment portfolio and reduce overall risk. This is because bonds generally have a low correlation with other asset classes, such as stocks.
Potential for capital appreciation: While bonds are primarily used for their income-generating potential, it is possible for the value of a bond to increase in price, providing potential for capital appreciation.
Safety: Bonds are generally considered to be less risky than stocks, as they represent a loan to a borrower who is obligated to repay the face value of the bond at maturity, as well as make periodic interest payments.
Tax benefits: In some cases, bond interest may be taxed at a lower rate than other forms of income, making bonds a tax-advantaged investment for some investors.
How Much Return to Expect from Bond Investments
For the US, for example, in January 2023 the yield for 10 year US treasuries offered by the US Government is around 3.5% while debt securities with shorter maturities yield higher (up to 4.8% for 6 months maturity). Currently, shorter durations offer a higher yield than longer ones, which is called an inverse yield curve and comes from recent aggressive interest hikes by the FED in 2022. The yield for even best rated corporate bonds is usually higher as the risk for default is considered to be higher compared to US Government bonds or bills. Both, government and corporate bonds behave differently during market turmoil, as explained in the article Which type of safe fixed income Bonds to own? Corporate or Government Bonds?.
Investing in Single Bonds Provides Cashflow Certainty
While searching for single bonds provides the opportunity to pick exactly the bonds you want to own and to influence your future cashflow from coupon payments and the point in time of repayment of the bond's face value (principal), it comes with the downsides of less diversification compared to a basket of bonds kept in a bond ETF and additional maintenance time for reinvesting cashflows after the bonds have reached maturity date. Also, trading of bonds is not as liquid as for stocks. Spreads might be high or buying/ selling even impossible due to lack of counterparts.
On the other side, when holding single bonds, you will be always paid back the face value of the bond at the end of maturity. For example, if a bond with face value of 100 EUR becomes due on 01st of January 2025, you will receive back the 100 EUR face value plus interests since the last coupon has been paid.
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The yield you will earn is composed of the coupons paid and the difference between the buying price and the bond's face value. For instance, if you buy a bond with a face value of 100 EUR at 70 EUR, you will receive back 100 EUR at the end of maturity, meaning, in addition to the coupons also a capital gain of 30 EUR making up the yield to maturity. In order to find out the annual yield for a bond, there are many bond calculators available on the net. A good one is also provided by Wolfram Alpha.
So, the advantage of investing into single bonds: you know how much you will receive back and when. That is something investors looking for certainty will appreciate a lot.
However, it's important to note that the specific risks and benefits of investing in individual bonds will depend on the creditworthiness of the borrower and the specific terms of the bond. Before investing in individual bonds, it's important to consider your investment goals, risk tolerance, and to conduct thorough research on the borrower and the bond in question.
Bond ETFs Provide Cheap Option for Diversification
By investing in a bond ETF the investor can only choose the type of bond ETF (corporate, government or aggregate as mix of corporate and government bonds), the average duration until maturity date of the bonds (e.g., short-run, intermediate, long-run), their credit rating (investment grade down to junk bonds with higher risk for default) and between accumulating and distributing bond ETFs.
The investor cannot plan the future cashflow as bonds in a bond ETF reaching maturity will be replaced by new ones at current yield level. If national bank's interest rates go up, bond prices will go down (the longer the duration the more). So, the price of the bond ETF unit will drop. And the only way to get rid of your bond ETF is to sell which can lead to a loss. When holding single bonds, this price risk can be overcome by simply holding the bonds until end of maturity in order to receive your money back at par value.
Another important difference between single bonds and a bond ETF is related to fees. For both type of fixed income investment you need to pay transaction fees for buying and selling. But for bond ETFs there is in addition a small administration fee (<0.2% TER) which of course lowers the return of the investment into the bond ETF. But compared to equity ETFs this fee is lower.
Bond ETFs provide instant diversification across a wide range of bonds, which can help to reduce overall risk and potentially increase stability in a portfolio. All in all, there are some potential advantages of investing in bond ETFs, especially compared to actively managed fixed income funds but also compared to investing in single bonds:
Diversification: Bond ETFs provide instant diversification across a wide range of bonds, which can help to reduce overall risk and potentially increase stability in a portfolio.
Convenience: Fixed Income ETFs are easy to buy and sell and can be traded just like a stock on a stock exchange. This makes it simple for investors to invest in bonds without having to individually research and purchase individual bonds.
Low cost: Bond ETFs often have lower expense ratios compared to actively managed bond funds, making them an attractive option for cost-conscious investors.
Liquidity: Fixed Income ETFs are highly liquid, allowing investors to quickly buy or sell their shares as needed.
Tax efficiency: Fixed Income ETFs tend to be more tax efficient than actively managed bond funds because they have lower turnover, which can result in fewer taxable events.
Access to niche markets: Bond ETFs can provide access to niche bond markets, such as high-yield bonds or international bonds, that may be difficult for individual investors to access on their own.
Pro Single Bond Investment | Pro Bond ETF Investment |
Specific maturity date provides certainty about future cashflow | Open end investment without maturity date ==> less maintenance effort |
Paying coupons | Distributing bond ETFs pay interests |
Certainty to receive back investment at par value | Easy to buy since very liquid and lower spreads than buying single bond |
No administration fees as for bond ETF | Better diversification |
In the end, it is up to the individual investor how to compose the own portfolio: with bonds or simply as a pure equity portfolio with significant higher volatility. This bond investment decision is also up to the investor's willingness to invest time to find the right bonds to buy (duration, rating, coupon, face value).
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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