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Bonds: what they are and how to profit from them?


Bonds are a suitable tool for a novice investor. We talk about the types of bonds, how to evaluate the income on them, what are their advantages and what risks you need to remember.

Bonds: what they are and how to profit from them


What are bonds and how to make money on them?

Bonds are actually IOUs. They are issued by an issuer - a company that needs money, or the state - it can also be an issuer.


People buy bonds and thus lend their money to that company or government, expecting to receive a certain income. The full amount, terms and amount of payments of this income (if several payments are planned), as a rule, are known at the time of purchase. The ability to estimate your benefit in advance is what distinguishes a bond from other securities.


The bonds are redeemed at the due date, that is, the issuer pays their owners the face value. There are also perpetual bonds - the issuer undertakes to regularly pay income on them, but may never repay them. At the same time, he usually has the right to redeem them at face value on certain dates - for example, once every five or ten years.


In addition to government and corporate bonds, there are also investment and structural bonds. They are issued by financial organizations, and they invest investors' money not in their own development, but in other stock instruments. These are complex products—buyers must evaluate the prospects not of a particular company, but of an entire investment strategy.


Investment and structured bonds are considered complex instruments because their returns are almost unpredictable. And in some cases, when they are redeemed, the owners receive even less face value. Read more about the features of such securities in the article "Structured products: what they are and whether it is worth investing in them" .


But the main risk for the investor is the bankruptcy of the issuing company. In this case, he may lose all the money invested: unlike deposits, they are not protected by the deposit insurance system.



What are the types of bonds?

Bonds differ in several ways.


By issuer:

State  -issued by countries or individual regions to cover the budget deficit.

Municipal  - issued by local governments, as a rule, to finance various projects.

Corporate  - issue companies to raise money for their development.

Investment and structural  - issued by banks, brokers and management companies in order to invest investors' money in other securities and receive a commission for this.

Private companies can also place a special type of bonds - commercial, which are distributed by address and by closed subscription. But it is impossible to just come to the exchange and buy them.


According to the form of payment of income:

Interest-bearing (coupon) bonds  - on them you will receive interest on the face value. Some bonds have only one payment, others have multiple payments.


The payment of interest is called coupon redemption. This name has been preserved since the days when bonds were paper: coupons were attached to them for payments, which were torn off at the time of redemption.


Most often, bonds have a constant coupon  - the interest rate does not change during the entire life of the bond. A  fixed rate is also common, when each payment period has its own coupon interest, but it is known in advance.


Variable Couponoccurs in long-term bonds - the rate is fixed up to a certain point, and then the issuer has the right to set another one, based on market conditions. Floating-rate


Bonds have the most unpredictable income among coupon sheets - the interest on them is correlated with macroeconomic indicators, such as inflation or the key rate of the state bank.


Discount Bonds - When purchased, their cost is less than their face value, but they are redeemed at face value. For example, you bought a bond at a discount - for $800, and when it expired, you received $1,000 for it - the entire face value. The difference between the placement price and the face value is called the discount.


Bonds with an indexed par value  - they can have a constant coupon, say 2.5% of the face value, but at the same time the face value itself changes regularly, for example, by the amount of inflation. Now several issues of government bonds are traded on the stock exchange with exactly this denomination, which depends on the rate of price growth in the country.


Bonds with structured income (investment)  - the income on them is not fixed and not guaranteed. It is only known in advance under what conditions what payment you will receive. For example, if the price of oil or a stock index falls within a predetermined range for a certain time, then the coupon yield will be 20%. If it exceeds this indicator, then 10%, if it turns out to be lower, the coupon will not be paid. The face value of the bond upon redemption will be returned to you in any situation in the financial market.


Structural bonds  - the terms of payments on them, as a rule, are even more complex than on bonds with a structured income. And in certain cases, you will receive even less money than you spent on buying this security. For example, the shares of four American companies can be taken as indicators on which payments depend. If the prices of all four increase by more than 10% during the life of the bond, then the coupon will be 20%. All will rise in price, but at least one less than 10% - you will be paid 12%. One will fall in price, and the rest will not - you will not receive income, but upon redemption, you will be paid the face value in full. If at least two drops in price, only 80% of the face value will be returned to you.

By maturity:

Short  -term - maturity less than a year.
Medium -term  - from 1 year to 5 years.
Long-term  - more than 5 years.
Perpetual or perpetual - no maturity date.

By issue currency:

Dollar .
Currency  - they are also called Eurobonds, even if their prices are in dollars or yuan.

By convertibility:


Convertible bonds  - they can be exchanged for other securities of the same issuer, such as shares.
Non- convertible bonds  - they cannot be exchanged for other securities.

By availability:

Secured  - the most reliable. Their owner is likely to keep his money. The safety of investments can be ensured, for example, by collateral - real estate and equipment of the company, other securities.
 That is, in the event of bankruptcy of the issuer, the owner of the bond will be able to receive this pledge - sell it and return his money.
 The second collateral option is the guarantee of another company.
 If the issuer goes bankrupt, this company will assume obligations under its bonds. The third option is a bank, state or municipal guarantee.
 This is almost the same as a surety. In this case, debts on bonds will be taken over by the bank, local or federal budget.

Unsecured  - less reliable. If the company goes bankrupt, bondholders will wait until the bankruptcy procedure is completed and their claims are satisfied in the general manner - along with other creditors of the company. Not the fact that it will be possible to return the invested money in full.

Subordinated unsecured bonds - are the riskiest. If the issuer of such bonds goes bankrupt, the investor will be able to count on the return of his money only as a last resort, after all other creditors. And after the distribution of other debts, there is rarely anything left. In cases where subordinated unsecured bonds are issued by a bank, and due to financial problems, the regulator sends it for reorganization , the debt on these securities is simply written off from the bank's balance sheet. Their owners cannot get their money back.

By way of contact:

Floatable bonds  - there are no restrictions on buying and selling such bonds. They can freely change owners: move from one investor to another.
Restricted bonds  - the purchase and sale of such bonds are restricted. For example, the owner cannot sell bonds for some time. Or the issuer sets limits on the price of bonds - when selling, it cannot be more or less than some limit. Or bonds are only for qualified investors  - if you do not have the status of "qual", you will not be able to buy them.

What bonds are available to novice investors?

Newcomers to the stock exchange can freely trade in fixed-income government bonds and diversify the portfolio. If we look at the US investment bonds, we will find that they rose by 4.5% and the shares fell by about 13%. Therefore, we advise newcomers to the stock exchange to have a more balanced portfolio of stocks and bonds, and this gives them Investment stability and low risk.

To buy bonds of  American  and foreign issuers with a  low credit rating , as well as structured bonds or bonds with a structured income, you need to pass a special test . Tests will show if you understand the features and risks of these tools. And they will also help you decide for yourself whether you are ready to invest in them.

Separate tests are provided for each type of risky bonds. With one broker or management company, it is enough to go through the check only once - before making the first transaction. If you want to contact another intermediary, you will have to answer the questions again.

Testing will test the level of your knowledge about the tool. For example, you need to choose the correct definition of a credit rating, answer how quickly an investor can sell low-liquid bonds, or calculate the amount of payments on a structured bond.

To successfully pass the test, you must correctly answer all the questions .

To prepare for the test, you can take training in advance. Where and how to get knowledge about the stock market, read the article "Where to learn to invest" .

At the same time, it should be borne in mind that some bonds, such as subordinated and most structured bonds, are intended exclusively for qualified investors  - if you do not have such a status, you will not be able to buy them after testing.

What taxes does a bondholder pay?

Income tax will have to be paid on coupon income (it is automatically calculated and retained by the issuer or depository) and on income from the sale of bonds (it is retained by the broker if the transaction was carried out through him).

In the case when you invested money in bonds through an individual investment account ( IIA ), you can get a tax deduction .

You can read more about how to calculate and deduct taxes on income from bonds in the text “ What taxes does an investor pay ”.

What risks might a bondholder face?


Investing is always a risk. When buying bonds, for example, you should consider:

Default - risk is the risk that the issuer will go bankrupt and be unable to meet its financial obligations to the investor. If you have purchased secured bonds, this risk is low. You are very likely to be able to return the money thanks to a pledge, guarantee or surety.

Liabilities restructuring  risk - the risk that the issuer will change the maturity of bonds, the amount of coupon income, the timing and frequency of payments. The company may offer new terms to investors if it finds itself unable to fulfill the original promises.

Liquidity - risk is the risk that you will not be able to quickly sell your bonds at a fair price if you choose to do so before maturity. There will be few or no people willing to buy your papers. Often this happens when the issuer has financial problems or is just an unknown company. It is also usually difficult to find a buyer for structured bonds and bonds with structured income.

Interest rate risk - is the risk that average market rates on similar bonds will become higher. If your bonds have a fixed interest rate and it turns out to be below the market rate, then you are a loser - your income could be higher if you invested in other securities.

For example, you bought a three-year bond with a yield of 10% per annum. A year later, the average market yield on similar bonds increased from 10% to 12%. It turns out that you will earn less than other investors who buy securities on new terms. And if you want to sell your bonds early, you will have to lower the price below par. Only then will your securities be of interest to another investor.


This risk is closely related to the movement of the key rate of the Bank of America, on which other rates in the financial market also depend. When the key rate decreases, the interest rate risk does not materialize. But when it rises, the yield of new bonds usually rises and the interest rate risk for holders of old bonds increases.

Inflation risk - is the risk that inflation will accelerate and outpace a bond's yield. It turns out that you will not increase your real capital, but will lose part of it. After all, tomorrow you can buy less with it than today.

Investors should always be prepared to lose money, but for structured bonds, the risk of loss can be singled out separately. After all, it is known in advance that, under certain conditions, at the time of repayment, you will be paid an amount below par.

How to minimize all risks?

It is worth remembering that the minimum risks, as a rule, mean the minimum profitability. This is market law.

The next most reliable can be considered bonds of the largest companies with a high credit rating , such as "AAA", and a moderate yield.

You can take a risk and invest part of the money in more profitable securities with an average rating - at the level of "B". But in this case, be sure to take into account the risks of default, debt restructuring and liquidity.

Before buying bonds, it is important to check how the issuing company is doing. Look at the news and study open financial and accounting reports - this data is available on the websites of the exchange and authorized news agencies. It is advisable to monitor the state of the issuer after the purchase of securities.

Read the rules for issuing bonds carefully. Find out how often the money will be paid out and through which organizations, where all important information about securities will be published. Specify whether the issuer has the right to early redeem or redeem the bonds and whether the owners of the securities themselves can demand to do this.

Pros and cons of bonds


Pros:
  • The yield on government, municipal and corporate bonds is on average higher than on a bank deposit, and it is usually set in advance. Or the rules by which it can be calculated are known.
  • Although buying fixed income bonds entails some risk, it is lower than investing in stocks and other instruments.
  • The value of highly rated bonds does not fluctuate as much as the price of other securities. Most often, they are easy to sell at a price close to face value.

Minuses:
  • Bond investments, unlike other stock market investments, are not covered by the deposit insurance scheme.
  • . In case of bankruptcy of the issuer, you can lose everything.
  • The yield of reliable bonds is low compared to more risky financial market instruments.
  • In the case of investment and structural bonds, the risk of not receiving income or even incurring losses is very high. It is difficult to evaluate it even for experienced investors.
The most reliable bonds available to everyone without testing - a suitable option for a novice investor. You can earn a modest income and save money with them while taking comparatively little risk.

The probability of losses when investing in other bonds is higher, although the profit may be greater. Therefore, before buying, you will have to study their risks and features, undergo testing.

It is important to remember that any investment can result in losses. If you trade on the stock exchange through a broker , it is you who make the final decision to buy or sell bonds and are responsible for it.

To reduce the risk of losses, it is worth diversifying investments - that is, investing money in securities of different companies from different industries.


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