What are the different ways of investing in bonds?
In recent decades, bonds have evolved into a $100 trillion global market. With such scale, there is a wide range of bonds for investors to choose from and many ways to gain access. Understand the different options available for bonds.
In recent decades, bonds have evolved into a $100 trillion global market. With such scale, there is a wide range of bonds for investors to choose from and many ways to gain access. But with this choice comes complexity. To make intelligent decisions about bonds, investors need to understand the different options available to them.
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, and supply and demand. In the secondary market, bond prices are quoted as a percentage of the bond’s face value. For more information on bond pricing, refer to Series 1, Topic 5 – What affects the price and performance of bonds?
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.
Listed versus over-the-counter securities
A key difference between shares and bonds is how they are traded in the secondary market.
Shares are traded predominantly through public securities exchanges such as the New York Stock Exchange, Australian Securities Exchange or London Stock Exchange.
Bonds on the other hand are quite different. While some bonds are traded on a public exchange, the vast majority are unlisted securities that trade over the counter (OTC) between large brokers acting on behalf of their clients.
One of the challenges of the OTC market is that it doesn’t offer the same price transparency as the public market.
Consider key factors like risk, methods of investment and market segment. Here are five key things to consider when investing in bonds.
Investors who are familiar with equity investing may want to invest directly in bonds in the same way they do with stocks. They may envision building their own portfolio of individual bonds.
However, direct investing in bonds can be difficult for individual investors for 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, the investor needs to have extensive knowledge of investing as well as access to research and other sources of data to assess the merits and pricing of the bond.
Indirect investing in bonds
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 will 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.
You can read more about active and passive investing in Series 3, Topic 2 – What’s the difference between passive and active investment in bonds?