Bond investment, as a financial instrument, holds a larger share in the financial market than stocks, yet the average investor is not sensitive to bonds, thinking that bond interest rates are low and the returns are not as good as stocks and funds.
What is a bond? As the name suggests, it is a promissory note issued by the bond issuer, usually the government or corporations, when they need funds. The note will specify the principal, interest, term, repayment time, and so on. Theoretically, a bond is a certificate that promises to repay the principal and pay interest.
I. Is the return on bonds fixed?
The return on bonds is not fixed. If you purchase a bond and hold it until maturity without buying or selling, then it is essentially fixed. However, this is generally difficult because investing emphasizes liquidity, the ability to quickly cash out when funds are needed.
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Since bond interest rates are also variable, for example, if you buy a 100,000 government bond with a 10-year term, a few months later you might find that the value of this investment in your account has dropped to 95,000. Why is that? The market price of government bonds also fluctuates. If the price has decreased over the past few months, such as due to a central bank interest rate hike, the market interest rate level might have risen from 3% to 3.5%. When interest rates rise, newly issued bonds will be calculated at 3.5%, higher than the original 3%. Consequently, many people will sell old bonds and buy new ones, which drives down the price of the old bonds.
The price of a bond changes inversely with market interest rates. When interest rates rise, bond prices fall. Conversely, when interest rates fall, bond prices rise. Therefore, your return on bond investment over a period is not entirely fixed, even though the principal and interest repayment are fixed, there will be price fluctuations. If you need to use money in the middle, you will have to bear the risk of price volatility.
Generally speaking, the longer the term of the bond you purchase, the greater the risk of price fluctuation. The risk of a 10-year bond is greater than that of a 5-year bond, and the risk of a 5-year bond is greater than that of a 1-year bond. Short-term bonds have a smaller risk of price fluctuation, such as bonds maturing in three months, but their return rates are also relatively lower. Long-term bonds carry a higher risk and a greater risk of interest rate volatility.
II. Can bonds default?Bonds are divided into corporate bonds and government bonds, which can also be referred to as credit bonds and interest rate bonds.
Interest rate bonds are issued by the government, backed by the government's credit. Common examples include treasury bonds, central bank bills, and policy bonds, such as those issued by the China Development Bank, the Agricultural Development Bank of China, and the Export-Import Bank of China. These are issued by the state or guaranteed by the state, with a low risk of default, but they are subject to interest rate fluctuations.
Treasury bonds are generally considered safe assets, but there have been instances of default in history. For example, Russia experienced a sovereign debt default in 1988, when the Russian government announced it could not repay its debt on time. In the international financial market, U.S. Treasury bonds are seen as the safest assets due to the strong national power of the United States.
Credit bonds are issued by companies. If a company goes bankrupt or becomes insolvent, there is a risk of default. The bond ratings we see, such as AAA, AA, BBB, BB, etc., refer to the default risk levels of bonds. They are divided into three grades, A, B, and C, with further subdivisions under each grade. Generally speaking, bonds with an A rating have a lower risk of default, while those with a C rating have the highest risk.
Chinese listed companies have experienced bond defaults, such as the "Chaori Bond" default in 2014 and the "Noble Bird" default in 2019, both of which caused significant commotion in the capital market. In 2018, 53 corporate bond defaults occurred nationwide, and in 2019, 65 corporate bonds defaulted. Due to the sluggish economy, the wave of defaults has continued in recent years.
III. How is the liquidity of bonds?
The liquidity of bonds is not as good as that of stocks. Treasury bonds have a large volume and are participated in by many institutions. When institutions are short of cash, they usually buy and sell bonds, making treasury bonds relatively more liquid and more active in trading.
Corporate and company bonds, especially those with lower ratings, have poor liquidity and are difficult to buy and sell.
Stocks have many participants, with many retail investors involved in trading, buying and selling, which provides liquidity. Bond investors are fewer, mainly institutions, and the trading volume is relatively low.
IV. For whom are bonds suitable?The characteristic of bonds is their high safety. Although the yield is not very high, it is still considerable and can form a good hedge with stocks. Therefore, if you are someone with high net assets, the allocation of bonds is actually quite safe. The interest rates provided by bonds can cover the cost of living.
Secondly, for the elderly, the future cash flow is less, mostly consisting of pensions. At this time, what is most needed is the preservation of assets to obtain a stable cash flow. Therefore, they can buy fewer stocks and more bonds.
On the contrary, young people have a strong ability to withstand risks, and they still have a long way to go. They pay more attention to assets with high long-term average returns, so they can allocate more to stocks and less to bonds.
V. What are the advantages and disadvantages of bonds?
Bonds are relatively safe products, and there may be occasional losses, but the losses are not significant.
Since bonds are fixed-income products, the main risks of bonds are interest rate risk and credit risk. Interest rate risk may cause the bond to fall a bit, but not too much, and there is also the return of principal and interest to cushion. Credit risk is the risk of default, as long as there is no large-scale default, the problem is not significant and does not affect the overall yield of bonds.
When investing in bonds, it is important to avoid some junk bonds. Since ordinary investors do not have an in-depth understanding of bonds, they can consider buying bond funds and bond ETFs.
Although the overall return on bond investment is not high, with an average annual return of only 4.62% from 2007 to 2018, credit bonds are a bit higher, reaching 5.45%. Because it is a risk-free return, it is actually very considerable.
At the same time, the investment return of the CSI 300 was compared, and the average annual return was only one point lower, which is quite good.After understanding the basic characteristics and advantages and disadvantages of bonds, we can make choices based on our own financial needs. Young people can also allocate bonds according to the corresponding asset proportion. Bonds have the characteristic of complementing stocks, and allocating bonds can diversify one's risks.