September 15, 2020 | AtoZ Markets – If you are looking to diversify your investment portfolio, bonds may be the missing piece of the puzzle. Bonds are some of the safest ways to invest your money if you are afraid of taking too much risk. Through bonds, your money is pulled into a fund that is loaned to agencies for a profit.
If you are interested in trading bonds, it is important first to understand what bonds are and how they work. Here is everything you need to know about trading bonds.
How bonds work
Whenever you buy a bond, you are loaning the money you use to invest in the bond to the issuer for a predetermined time. In exchange, the bond issuer promises to pay regular interest payments at an agreed rate, until the bond contract expires. Once matured, the bond issuer will need to repay your principal, after which you can decide to reinvest or not.
For instance, you can invest in a 10-year bond worth SG$10,000 paying 3% in interest. The issuer of the bond promises to pay a 3% interest in your investment every six months. Upon the lapsing of the 10-year contract period, they will need to pay you back the SG$10,000 principle.
It is important to note that there are exceptions to the rules of trading bonds, like the zero-coupon bonds. These types of bonds do not pay interest but are sold below their actual value. Even so, most bonds follow the borrowing interest formula.
How to make money from trading bonds
There are two main ways to make money from trading bonds.
The first method involves holding the bonds until the maturity date while collecting interest paid semi-annually at a predefined interest rate.
The second method involves selling the bonds at a price that is higher than the amount you invested. This second method is the principle non-interest bonds are built on. For instance, you can buy a bond worth SG$10,000 at face value and sell them at SG$13,000 after the market value increases. This way, you get to pocket the difference as your investment profit.
Types of bonds
There are different types of bonds you can invest in. Each of these types has its benefits and drawbacks, which are important considerations to make before investing.
These are types of bonds issued by corporations as a way of raising capital for business-related needs. These needs can be research, expansion, or development. Corporate bonds come with higher interest rates than government-issued bonds and other types of bonds. However, the interest is taxable.
Also referred to as municipality bonds, these types of bonds are issued by cities, states, and other public institutions for public projects or services. For instance, a city may issue bonds for a bridge-building project or revamping a neighborhood park.
These bonds are further divided into general obligations bonds and revenue bonds.
A general obligation bond is fully backed by faith and credit to the issuer. This way, the issuer can use any method necessary to raise the money intended to repay the bondholders in time. Revenue bonds are backed by an income stream tied to the project. For instance, if a city issues bonds to build a road, the toll proceeds’ are used to repay the bondholders.
The two types of municipal bonds pay interests that are exempted from government taxes. The interest on municipal bonds is lower when compared to other types of bonds.
Also referred to as T-bonds, these are issues by the Singapore government. The interest you receive from treasury bonds is taxable. Treasury bonds mature after a minimum of 10 years, and are backed by the full faith and credit to the national government. This is why they are considered risk-free investments, even though they come with low interest rates.
Are bonds the right investment for you?
If you are heavily invested in other securities, bonds can be an ideal way of diversifying your portfolio. This can cushion you from the market volatility common with trading other securities. If you are a risk-averse type of investor, bonds are the safest type of long-term investment.