Caution - The Differences Between Investing In Bonds And Trading In Bonds
Like many investments, bond investing is not rocket science, but it is, like every other financial transaction, something to be carefully considered before jumping in. All the differences between investing in bonds and trading in bonds are understood by the professionals who work with bond investment every day, but are less obvious to the retail bond investor.
If you are intending to be investing in bonds as opposed to speculating in bonds, then you will need to understand the basics of how the markets work, and how to tell an investment-grade bond from a junk bond.
A bond is much like a term deposit that you make with a bank - you give your money to the bond issuer, and they agree to pay you interest (called the coupon rate) each month until the bond matures, at which time they will return your investment.
Obviously, if the bond is being issued by the US government, you can be reasonably confident that the money will come back to you when the bond matures in ten years’ time. On the other hand, if the bond was being issued by Slippery Joe’s Used Cars And Auto Parts Barn, located in Pipsqueak, Utah, you may not be quite so certain …
Bonds are rated based on a number of factors, all of which affect the likelihood that you will get your money back when the bond matures. The highest rating, AAA+, is applied to extremely secure investments like government bonds. Other large, reasonably stable organisations would be rated at various levels of A, down to A-.
Bonds that are rated as low as BBB can be considered “investment grade”, but once you get below that level the risk of default is too high for the bonds to be considered investment grade. The risk is still not large in percentage terms, but for a fixed-income investment, you really don’t want to lose that lump sum, or even a part of it.
The lowest risk strategy for bond investment is bond investment. When it comes to the differences between investing in bonds and trading in bonds, the key point to remember is that reward is always commensurate with risk. If a bond is paying a high coupon rate, it is because nobody will buy it at any lower rate, due to the perceived risk.
There are ways to trade and speculate in bonds, and achieve higher returns with equivalently higher risk. However, if you are at the point in your investing career where you are looking for secure fixed income, then you don’t want to be taking those risks. At that point, you should be investing in bonds as opposed to speculating in bonds. Consult your investment advisor to determine which bond investing strategies are appropriate for your situation.
It is vital that you are fully aware of the the different types of bond investing before you start your bond portfolio, or you could find yourself exposed to significantly more risk than you had intended!