What is an income bond

Bonds

What you should know about investing in bonds

Hendrik Buhrs
Expert for banks and stock exchanges As of October 30, 2020

Hendrik Buhrs

Hendrik Buhrs is an editor in the bank and insurance team. Before joining Finanztip, he reported on economic and consumer issues for the radio programs of the Hessian and later of the West German Broadcasting Corporation. Hendrik studied economics in Münster and Exeter. He gained his first professional experience at Radio Q and on Recklinghausen local radio. He likes to invest the money he has saved in travel.

  • Bonds are securities that are usually characterized by fixed interest payments.
  • They are issued by states and companies that use them to raise money on the capital markets.
  • So whoever buys a bond gives the issuer a loan.
  • The range of bonds is very broad: there are very safe, but also high-risk versions.
  • You can buy bonds individually or in mutual funds. These bond funds spread the risk across many individual stocks but charge annual management fees.
  • Bonds currently only have very low interest rates. Ordinary returns are only possible if the interest rate level falls even further. We recommend overnight and fixed-term deposits as alternatives.

Regardless of whether Dax, Dow Jones or MSCI World: When it comes to stock market reports, the focus is usually on the stock markets. The bond markets are also interesting. The German state alone currently has bonds worth over 1.2 trillion euros in circulation (as of September 2020). According to information from Deutsche Börse, around 16,000 shares but 29,000 bonds can be traded on the German market.

Some private investors also deal with bonds, as they are generally suitable as a relatively safe investment for long periods of time. The price fluctuations of bonds are on average smaller than that of stocks. Bonds that are traded on the stock exchange can be resold by investors. This is a decisive advantage compared to fixed-term deposits, where you are tied to your bank.

Here's what you need to know about bonds

At the moment, however, bonds only have low interest rates. The expected return on a ten-year federal bond has even been negative for some time and was -0.6 percent per year in October 2020. Call money accounts with good interest rates, where you get your money every day, currently offer a higher return.

In its basic form, a bond is a security that promises you regular fixed interest payments. However, in the past few decades many new types of bonds have been developed and launched.

At first glance, bonds seem like complicated securities. On closer inspection, however, they can be easily understood if you know the most important properties:

Return - The most important key figure is the expected annual return, which results from the term, the fixed interest payments, the purchase price and the repurchase price of the bond. The return is given in percent. It is the annual interest that an investor can expect if he keeps the bond in his custody account until the end of the term. The most important factors influencing the return are the market interest rate, the remaining term of the bond and the financial strength of the issuing state or company. The longer the term and the lower the credit rating, the more return you can expect.

coupon - Most bonds pay out regular interest payments, also known as coupons. But the coupon and the yield are not the same. While the coupon is fixed, the yield on bonds fluctuates daily with their prices. When bond prices rise, the yield falls; when bond prices fall, it rises.

Face value - The face value is the amount that is on the bond and at which it is usually repaid. Bonds that are also to be sold to private investors often have a face value of 1,000 euros.

Market value - The price of bonds is given as a percentage of their face value. A rate of 100 percent corresponds exactly to the face value. A price of 110 means that the bond's value is up about 10 percent from face value.

Remaining term - The remaining term indicates when the bond will be repaid.

Rate fluctuations - The prices of bonds fluctuate. This is due to the fact that the return adapts to the current interest rate level. When interest rates fall, bond prices rise. When interest rates rise, they fall. The interest rate level is influenced by many factors. The most important are economic growth, expectations about inflation and the monetary policy of the central banks. If the central banks lend cheap money, this usually depresses interest rates.

trade - You can buy and sell bonds on the stock exchange. Bonds are traded differently. In technical jargon, one also speaks of liquidity. If the securities are traded less often - that is, less liquid - you can expect a higher return. In the event of a resale, however, you have to expect deductions, as it is not so easy to find a new buyer.

Single purchase or fund - You can buy bonds either individually or as a fund. A fund has the advantage that you invest in several bonds. This reduces the risk of loss due to a payment default. The fund manager charges an annual fee for this. We prefer the fund solution, especially for riskier bonds, as this allows you to spread the risk across a large number of individual stocks.

Currency fluctuations - With bonds that are not issued in euros but, for example, in US dollars, you take a currency risk. That can be higher than the interest on the security itself. So be aware that possible currency fluctuations can have a significant impact on your profit or loss - even if you buy a secure bond.

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Bonds are hardly worthwhile at the moment

Government and corporate bonds from economically sound countries and corporations generally belong to the safe investments and are best comparable to fixed-term deposits: The buyer invests a certain amount, receives interest in return and the nominal value of the bond back at the end of the term. Fixed-term deposits currently bring higher interest rates than a bond from the same bank and the associated country with a similar term. In addition, the deposits of up to 100,000 euros per bank and per person are legally protected by the deposit insurance. However, it is difficult for investors to get their money before the end of the term. In most cases, early termination is not possible or only possible with waiver of the interest payment.

Bonds, on the other hand, have the advantage that some of them, such as federal bonds, are traded on the stock exchange and can be resold at the current price. So you can get your money ahead of time. However, bonds are not subject to deposit insurance. In the event of the publisher's insolvency, you are usually on an equal footing with other creditors and you have to expect losses.

Currently, however, even the best overnight money accounts offer higher interest rates than government bonds with terms of more than ten years. Even higher returns can only be achieved with speculative bonds whose issuers have a low credit rating. The risk of loss with these bonds is very high, while losses are as good as impossible with a call money account. We therefore recommend that you use overnight money and fixed-term deposits with terms of up to three years. We currently advise against long-term interest investments.

Individual bonds in comparison

There are now a large number of different bonds: very safe bonds such as German government bonds, but also high-risk bonds such as convertible bonds. No matter which bond you want to invest in, you should always be aware of the risks and only invest your money if you actually understand the product. The most important bond types at a glance:

Government bonds - These are bonds that are issued by states like the Federal Republic of Germany. The terms range from a few months to more than 30 years. Government bonds from financially strong countries are considered to be the safest bonds of all. A special form of government bonds are so-called inflation-indexed bonds, the interest payment of which depends on how the inflation rate develops.

Corporate bonds - Many companies issue bonds to finance themselves. The expected return depends on both the term and the creditworthiness of the company. The higher the financial strength of the company and the shorter the term, the lower the interest payment you will receive.

Subordinated bonds - With these bonds, in the event of the issuer's bankruptcy, you will only get your money back after all other creditors. For this higher risk, you get higher interest rates on subordinated bonds. Most of these bonds are issued by banks and insurance companies.

High yield bonds - They are a riskier form of government and corporate bonds. The countries and companies that issue these bonds have a comparatively low credit rating. In principle, all bonds are considered high-yield bonds that are rated “BB” or worse by the rating agencies. Colloquially, one also speaks of junk bonds, "junk bonds" or "high-yields". High yield bonds offer higher yields than papers from issuers with better credit ratings, but they are also more risky.

Convertible bonds - These bonds are a mix of stocks and bonds. You can exchange convertibles for stocks at a certain price. Depending on the characteristics of the security in question, they behave more like stocks or bonds. They are high-risk and very complex products and therefore only suitable for experts.

Bonds - These are corporate bonds with additional security features. In the event of the issuer's insolvency, additional assets are available to secure the Pfandbriefe. Mostly these are real estate loans. In return, the return on Pfandbriefe is lower than on comparable corporate bonds.

This is how bonds work

The issue price of bonds is usually 100 percent of the face value. Due to fees or small changes in interest rates during the placement phase of the bond, the price can also deviate slightly from this. If you hold the bond until the end of the term, your return is roughly equal to the annual interest payments. However, the price of the bond fluctuates during the term. This results in a new expected return until the end of the term. Two factors, which are constantly changing, influence this rate of return:

current market rate: It is based on the interest rate for the federal bond with a corresponding term.

Credit markup: Compared to Bunds, companies have to pay higher interest because of their lower financial strength. In technical jargon, the premium is often referred to as the "spread".

example: The bond of a German company is issued at a rate of 100 percent. The annual interest payment (coupon) is 5 percent and corresponds to the expected return. If the current market interest rate on government bonds with a similar term is 3 percent per year, the company's risk premium is around 2 percent per year.

This means that you are taking two risks when you buy a bond: firstly, that the interest rate on safe government bonds will change and, secondly, that the issuer's creditworthiness will deteriorate. Because these values ​​can change, bond prices fluctuate.

The so-called modified duration indicates how much the prices fluctuate. It states the percentage by which the value of a bond increases or decreases if the interest rate changes by one percentage point. The modified duration shows the opportunities and risks of interest rate changes. The shorter the average maturity of the bonds in a fund, the lower the modified duration - and vice versa. The following two examples show how the price of a bond changes when the market rate or the credit spread vary.

example 1

You buy a corporate bond with a 5 percent coupon that is issued at 100 percent face value. Shortly afterwards, the market interest rate changes. It drops by 1 percentage point, so the company would only have to pay 4 percent if it issued a new bond. The change in the interest rate level has the following effect on the bond purchased, depending on how long the remaining term of the paper is:

Change in the price of a bond when the interest rate drops by one percentage point

Remaining term in years1510
Modified duration1,04,37,7
Rate in percent101104108

Source: Finanztip calculation

Example 2
If the interest rate does not fall by 1 percentage point, but increases by 1 percentage point to 6 percent, this has the following effect:

Change in the price of a bond when interest rates rise by one percentage point

Remaining term in years1510
Modified duration1,04,37,7
Rate in percent999693

Source: Finanztip calculation

Basically, a bond's price rises when the interest that the company would have to pay for new bonds decreases. This is also logical, since with the old bond you receive even higher annual interest payments and this is therefore more valuable. For the rate change of the bond, it is irrelevant whether the current market interest rate or the credit rating change changes.

If you buy a bond and you are sure that you will keep it until the end of the term, you do not care about price fluctuations. The key figure for you is the expected return at the time of purchase. It results from the nominal interest rate, the current price, the remaining term and the repurchase price of the bond.

Buy individual bonds or funds

You can purchase bonds either individually or in funds. Funds with bonds are known as bond funds. Depending on which variant you choose, you should consider the following:

running time - If you buy individual bonds, you usually keep them until the end of the term and only sell them under special circumstances. This strategy is also known as “buy and hold”. As a result, the bond is less susceptible to price fluctuations over time. In a fund, on the other hand, there are many stocks that are exchanged as soon as they no longer meet the criteria. In this way, the duration remains largely constant over time. This means that a fund always reacts similarly to changes in interest rates. If interest rates fall over a long period of time, as has been the case for a long time in the past 30 years, you can benefit from price increases with a fund in addition to the interest payments.

security - Bonds have different levels of risk. The ratings from rating agencies provide an assessment. We recommend that you only purchase individual bonds from financially strong companies or states. These have a credit rating of "AA" or better.

costs - There are annual administrative costs for an investment fund. If you buy individual bonds, you only have to pay transaction costs when buying and selling them.

How to buy cheap bonds

Before we explain how to buy individual bonds, let's briefly explain how investing in funds works. We will inform you in detail in the pension fund guide.

If you prefer funds

As with equity funds, the same applies to bond funds: the higher the annual management costs, the lower your return tends to be. We therefore recommend that you rely on so-called index funds or ETFs. These are funds that replicate the performance of an index and are therefore cheaper than actively managed funds whose managers try to beat the index by carefully selecting individual stocks. ETFs are not only available for stocks, but also for bonds.

While bond ETFs cost around 0.2 percent per year, actively managed funds charge between 0.5 and 1 percent per year. These costs are listed in the sales prospectus as the Total Expense Ratio (TER). In addition, when buying actively managed funds, there are often one-time sales charges of 3 to 5 percent.

If you are looking for an ETF, you first have to select the corresponding index. Depending on the bond type, there are different indices for which you can purchase funds. In the table below we have listed some indices from the most important categories for which you can buy index funds.

indexcategoryETF costs
(TER, in% p.a.)
eb.rexx Government GermanyFederal bonds0,16
Iboxx Sovereigns EurozoneEurozone government bonds0,15
Bloomberg Barclays Euro Government Inflation LinkedEurozone inflation-linked bonds0,25
iBoxx Euro Liquid Corporates Large CapEurozone corporate bonds0,2
iBoxx Euro Liquid High YieldEurozone high yield bonds0,5
iBoxx EUR Germany CoveredBonds0,15

Sources: just ETF, iShares, Markit (as of October 30, 2020)

In order to search specifically for index funds for bonds, we recommend the search function of your custody account or, alternatively, the portals just ETF or boerse.ard.de. To do this, select “Pension funds” for fund type and, if necessary, enter a search term such as “High-Yield” into the input mask. When choosing funds, also pay attention to the fund volume. We advise against funds with relatively small assets of less than 50 million euros, as these are less often traded on the stock exchanges. If you'd rather get a complete overview of the ETFs available in Germany, you will find an overview here.

If you want to buy individual bonds

Take a close look at the metrics on a bond before considering a purchase. Above all, you should pay attention to the rating because it gives you an idea of ​​the default risk associated with the respective bond.

Also pay attention to the tradability. Bonds that were only issued to a small extent, for example only for 50 million euros, are usually traded less. It can therefore be difficult to find a buyer. In the case of bonds with an issue volume of 1 billion euros and more, on the other hand, this is usually not a problem.

Another important key figure is the return that you can expect until the end of the term. Also, make sure what currency the bonds are denominated in. If it is a question of euro bonds, you do not take any currency risk.

We recommend that you search for suitable bonds via the portals onvista.de or finanzen.net, for example.

Buy the security from an online broker

Make a note of the securities identification number (WKN) or ISIN number of the bond or fund you have decided on. Another tip: use the option of a limit order when buying. You specify a price that must not be exceeded when buying. In this way, you can be sure that the purchase price is not too high, even with less liquid bonds.

We recommend that you make the purchase through a direct broker, as they often offer favorable conditions.

More on this in the securities account guide

  • With the right securities account, you pay little for buying and selling equity funds (ETFs).
  • Finanztip recommendations: Among the cheap and versatile custody accounts did the best: ING, Comdirect and Consorsbank and DKB. The cheapest providers are: Smartbroker, Scalable Capital (Free Broker) and Trade Republic.

To the advisor

Hendrik Buhrs

Hendrik Buhrs

Hendrik Buhrs is an editor in the bank and insurance team. Before joining Finanztip, he reported on economic and consumer issues for the radio programs of the Hessian and later of the West German Broadcasting Corporation. Hendrik studied economics in Münster and Exeter. He gained his first professional experience at Radio Q and on Recklinghausen local radio. He likes to invest the money he has saved in travel.

Sara Zinnecker

Sara Zinnecker

Sara Zinnecker was editor for investment topics until June 2020. Sara had previously written about investments and retirement provision for the Handelsblatt. She completed her traineeship at the Georg von Holtzbrinck School for Business Journalists.

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