Bonds 103: Consider Various Ways of Investing in Bonds
What you will learn
- Different ways of investing in bonds
- Differences between bond and equity investing
- Complexities of bond investing
What are the primary and secondary bond markets?
Just like stocks, bonds can be bought and sold in both the primary and secondary market.
When a government entity or a company wishes to raise debt, it can issue bonds or other fixed income securities via the primary market. Typically, a bank or investment bank helps sell these bonds. Such bonds are sold at face value. For example, if a bond has a face value of $50,000, the investor who buys it will pay $50,000.
Once the bond is issued, it can then be bought and sold in the secondary market. A key difference in the secondary market is that bond prices fluctuate in response to several factors such as the economic outlook, changes in the credit quality of the bond or issuer, as well as supply and demand for the bonds. In the secondary market, bond prices are quoted as a percentage of the bond’s face value.
Generally, bonds issued in the primary market are not available to individual investors. Rather, it is common practice for institutional investors to buy these bonds and then break them down into smaller parcels for sale to investors via the secondary market. To buy and sell in the secondary market, an investor needs to open an account with a bond broker.
What are publicly listed securities and over-the-counter securities?
A key difference between stocks and bonds is how they are traded in the secondary market.
Stocks are traded predominantly through public securities exchanges, such as the New York Stock Exchange, Australian Securities Exchange, and London Stock Exchange. Bonds are traded on a public exchange, with the vast majority being unlisted securities that trade over the counter (OTC) between large brokers acting on behalf of their clients.
One of the challenges of the is that it doesn’t offer the same price transparency as the public market.
What is direct bond investing?
Direct bond investing is typically for investors who want to build their own portfolio of individual bonds.
However, direct bond investing can be difficult for individual investors due to several reasons. First, the minimum investment amount for bonds is generally high, making it difficult to build a diversified portfolio without a large amount of money.
Second, as mentioned above, the OTC market (where most bonds trade) lacks price transparency. To invest in this environment successfully, investors need to have extensive investing knowledge, as well as access to research and other sources of data, to assess the merits and pricing of the bond.
What is indirect bond investing?
Owing to the challenges of direct investment in bonds, many individual investors access the bond market indirectly through bond mutual funds or exchange traded funds (ETFs). These funds provide investors with access to a wide range of bonds within a clearly defined set of parameters, such as geographic focus, credit quality and average duration.
Investors can choose from a number of different investment strategies, depending on the role bonds play in their portfolio. Some investors prefer passive investment strategies such as buying and holding bonds until maturity or investing in portfolios that track bond indices.
Others prefer active investment strategies which employ a number of different techniques in an effort to outperform bond indices, often by buying and selling bonds to take advantage of price movements.
Disclosures
A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.
The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.
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