Abstract: Through my practical bond investment experience and case study, demonstrate the advantages, characteristics and operations of bond investing. And further explain why bond is an important constituent in a portfolio, especially for those who require regular cash flow.
A little bit of comparison between stock and bond
I believe most investors do not have the experience in bond investment since stocks are the definite investment choice for them. There are certain clear advantages for stock investments, such as high liquidity and there are huge quantities of companies that you can pick. However, bonds have some unique features that stocks cannot provide. For example, bond can give you stable and regular cash distribution no matter if the company is earning or losing in operation. (Besides the bankruptcy of the company)
How to buy bonds?
Investing in bonds is not as easy as investing in stocks. Retail banks and brokerage houses usually do not provide bond investment services. In order to trade bonds, you need to open a private banking account in some large banks or use some professional bond investment platforms like BondSupermart online platform. But their minimum investment threshold is usually quite high, like US$100,000 or US$200,000. In my case, I use Interactive Brokers to invest in bonds, where you can buy bonds with a small lot of just US$1000 and the commission fee is quite low, merely US$1 for buying US$1000 bonds.
How to calculate bond coupon payment?
The bond coupon payment is the regular interests that paid out by the company. It is quite different from stock dividend payment. I think the former one is much fairer and friendlier for investors. Regarding stock dividend payment, if you buy the stock before its ex-dividend date, you will be paid with the dividends even if you do not hold the stock before receiving the dividends. On the other hand, the bond coupon payment is completely different and is usually distributed in every six months, sometimes some bonds are distributed in every three months or even every month. Let me use a real example of mine to demonstrate it, I bought a bond from an American company called Chemours Co, whose bond identifier is CC 7% 05/15/25, in which the first part “CC”is the short form of the company Chemours Co, the second part“7%”is the coupon rate, the last part “05/15/25”is the bond maturity date May 15, 2025. Since the coupon payment period of this bond is six months, it distributes the coupon on May 15 and November 15 each year. Moreover, when you are buying a bond, actually there is someone who is selling that bond to you. In this case, apart from paying the principal to the seller, you also need to prepay the bond coupon to the seller from the date of the last coupon payment to the transaction date. After that, of course you can also sell the bond at any time to get back the principal with the bond coupons. Let me use my example to explain the calculation in detail, I bought a quantity of face value US$3000 of the bond CC 7% 05/15/25 at the unit price US$103.25 on March 19, 2021, here the unit means each US$100 face value of bonds. So the principal that I paid was US$3097.5 (103.25*30), and I also have to pay the bond coupon US$74.67 to the seller (this is the bond coupon from November 15, 2020 to March 19, 2021. Note I haven’t calculated and verified this number, you may try it.) And the commission fee was US$3, so totally I paid US$3175.17. After that, I received the bond coupon payment of US$105 (interests calculated from November 15, 2020 to May 15, 2021 and should be calculated in the formula 7%/2*$3000) on the next payment date May 15, 2021. As you can already see, the bond coupon is calculated on a daily basis, which is definitely fair and really predicable.
Bond coupon rate vs bond yield
The bond coupon rate was determined once the bond was initially issued. As for the bond in my example above, its bond coupon rate is 7%. On the other hand, the bond yield or yield to maturity, which is calculated according to factors like bond coupon rate, the bond price that you purchased, and the remaining duration until bond maturity, is the average annual return of the bond. If in case you bought a bond at the price as the same as its bond face value, then you would get the bond yield equal to the bond coupon rate. In my example above, the yield of the bond I bought was 6.07%. You may also try to use this “Bond yield calculator” to help you get the yield-to-maturity of your bond. As you can see, when we invest in bonds, we have to calculate the bond yield because it is exactly the average annual return that we should expect to receive over the investment period rather than the bond coupon rate. In addition, if a company is operating smoothly with excellent cash flow and thus does not have any default risks, then its bond price usually rises and hence the bond yield drops accordingly. What is more, why do we always say bond has a more definite and predictable return? It is because when you buy a bond, the bond yield is then determined and so your annual return on your investment (ROI) is fixed and will not be changed no matter how the company is running, of course except in the case of bankruptcy, and you will receive a regular and predictable coupon payment until the bond maturity.
What happens to my bond on the bond maturity date?
After the bond is matured, the company will buy back your bond at the price of the bond face value and the bond will be cancelled out. As in my example above, although my purchase price of the bond was US$103.25, the company will only buy back my bond at the face value US$100. But this difference should have been already considered when we calculated the bond yield.
Bond credit ratings
The borrowing cost of a company is determined by its credit rating, the higher credit rating it gets, which means more stable and better cash flow the company is, the lower default risk it has. In addition, the size of the company, which industry the company is in, currency interest rate and the market sentiments can all influence the credit rating. There are three internationally recognized credit rating agencies, they are Standard & Poor, Moody and Fitch. The detailed explanation of these can be found in this link. In my example above, the bond I bought has the crediting ratings of B (S&P) and B1(Moody).
How to lower the risks of bond investment?
Many investment experts may tell you that the best risk lowering method is to only invest in higher credit rating companies’ bonds. Let me tell you my opinions through my bond investing experience. Although investing only in higher credit rating bonds can definitely lower the risks, the return will then be significantly lowered as well. What I think feasible is that you should not concentrate only on a few numbers of bonds, but rather try to diversify your investments in different industries and types of company bonds to lower the risks. The fact is that the major risk of investing in bonds is the companies may go bankruptcy. If for example you buy 20 bonds on average, then each bond shares just 5% of your entire bond portfolio. Then, if unfortunately one of them goes bankrupted, you will only lose 5%. Just as I had discussed in the previous article “Two basic investment logic – Capital gain vs Fixed income”, in order to pursue higher returns in capital gain type investments, one should avoid over diversification. However, you should just do conversely in case of bond investment, because you are not in pursuit of high returns, instead you should look for stable and average returns. Therefore, the lower risk caused by diversification and average returns will be just fine for bond investors.
Another common risk of bond investment
In my personal bond investment experience, one of the common risks of bond investment is from the investors themselves. It is caused by the investors’ false belief of bond investment, many of them trade bonds just as they do in stocks. They may buy a bond today and sell it the other day long before the bond maturity. One very important point, we should never put any emergency funds in bond investment, otherwise, we will have to sell the bonds in order to cash out when we need money. This is such as a huge mistake that you may commonly see in many bond investors. One should clearly note that there are ups and downs of the market, although the fluctuation is usually much lower for bonds than for stocks, however, the bond price may change at any time according to the market sentiment. If you sell the bond right at the market low point, you will have to suffer loss. Therefore, the correct bond investment mentality is always to hold the bonds till its maturity. Here, a small tip for you is that you may certainly buy some bonds with shorter maturity, say less than 5 years.
What types of investors are suitable for investing in bonds?
Everyone may have different views and answers. Buy generally speaking, just as what I said above, if you are now in pursuit of high returns, instead you just want stable and average returns, for example, when you are in retirement or already reach financial freedom, you should seriously consider allocating a higher percentage of bonds in your portfolio. Right now, I am managing a portfolio “Fixed income portfolio” for my retired family members. You may go there to have a look if you are interested.
Bond yield calculator
Now, you may use the “Bond yield calculator” on our website to help you calculate the yield-to-maturity for your bond, so that you can estimate the annual return rate of your bonds.
Comments and sharing
I am going to finish it here. If you have any questions, please feel free to leave a message or comment below, I will reply you. Or if you find anything incorrect in the article, please let me know and learn from you. If you find it interesting or it may help you in any sense, please share with other people.