Investing in Bonds: The Complete Guide
Bond investing is often overlooked compared with investing in stocks. But that doesn’t mean there’s no place for bonds in your investment portfolio – there absolutely is. In this article, we’ll cover everything you need to know about bonds.
Reading time: 24 min
Written by:
Dan Malone
What Is A Bond?
A bond is essentially an IOU, and can be thought of as a type of loan. With this type of investment, you’re lending money to a government or a company with the promise of being paid back with interest over time.
Bond Basics
Unlike stocks, bonds are a form of debt. When you buy them you become a debt investor. Being a debt investor means that you’re the beneficiary of some type of loan. You are the one who receives the loan repayment plus interest.
Bonds are used by governments and corporations as a way of raising money. Imagine the Irish government needed to raise €5 billion to improve infrastructure. One way they could raise that money is by issuing €5 billion worth of government bonds. This might look something like 5 million bonds issued for €1,000 each. The price of €1,000 is what’s known as the face value of the bond.
Investors, primarily institutional investors like banks, investment funds and hedge funds, purchase these bonds on the primary market directly from the issuer. The issuer gets their money and the investor gets what’s effectively an IOU. The issuer agrees to repay the investor the face value of the bond at some point in the future, plus interest.
That point in the future is known as the maturity date. Maturity dates on bonds can vary from short-term (i.e. less than 3 years) to medium-term (i.e. from 4 to 10 years) to long-term (i.e. more than 10 years). The maturity date of a bond will impact what is perhaps the most important aspect of the bond: the coupon.
The coupon is another name for the interest rate that’s attached to the bond. For example, say an investor bought a bond with a face value of €1,000 and a coupon of 4%. The investor would expect to receive €40 worth of interest from that bond each year until maturity, at which point the €1,000 would be repaid.
As a rule of thumb, the further away a bond’s maturity date is, the higher the coupon will be. This is because investors expect to be compensated for the additional risk of holding long-dated bonds. There is additional risk because more factors can negatively impact the issuer’s ability to repay the bond over longer time periods, relative to shorter time periods.
Key Insight: Bonds typically pay interest either annually or semi-annually. Most investing platforms will display this information, along with the next coupon date. If not, you can search the bond’s International Securities Identification Number (ISIN) online to see the interest payment frequency and other important information.
The risk of non-repayment by the bond issuer is known as default risk – which varies depending on the issuer. Fortunately, we have credit ratings. Institutions like Standard & Poor’s, Moody’s and Fitch provide letter grade ratings to the bonds that are issued by both governments and corporations. These ratings are assigned in accordance with the issuer's capacity to meet its financial commitments. The higher the grade, the safer the bond – in theory.
For example, Ireland’s sovereign debt was recently upgraded by Standard & Poor’s from AA to AA+, giving Ireland the second highest investment grade rating that exists. Investment grade means that there’s a low to moderate risk of default, whereas speculative grade signals a higher risk of default or an actual default.
Key Insight: As a rule of thumb, the lower the credit rating, the higher the coupon. This is to compensate investors for the additional default risk of investing in low-rated bonds. That’s why governments want to have a high credit rating. It makes it cheaper for them to borrow money using the bond market. Their bonds will have a lower coupon, lessening the repayment burden on public finances.
The other factor which influences the coupon is the prevailing interest rates that are set by monetary policymakers like the European Central Bank, the Bank of England and the U.S. Federal Reserve. When interest rates are high and rising, new bonds issued by governments and corporations tend to offer higher coupons than similar bonds that were issued in the past. When rates are low and falling, the opposite is true. This is because the newer bonds are reflecting the current interest rate environment.
The Relationship Between Interest Rates & Bond Prices
There’s an important relationship between prevailing interest rates and bond prices, but first, we need to understand par value.
Par Value
Let’s continue with our earlier example of a bond with a face value of €1,000. When you go to look up the price of that bond, you might find that the quoted price is “100” – not €100, just 100. The quoted price is actually the percentage of face value that the bond is currently trading at.
If the bond has a quoted price of 100, that means that its current market price is 100% of face value, which is €1,000. In other words, the current market price equals the initial face value. When this happens, the bond is said to be ‘trading at par’ or ‘at par value’. In reality, par value and face value are the same thing, but you’ll commonly hear that a bond is currently trading at, above, or below par.
If the quoted price was 90, then the current market price would equal 90% of face value, which is €900, a ‘discount to par’. If the quoted price was 110, then the current market price would equal 110% of face value, which is €1,100, a ‘premium to par’.
Rates & Prices: The Inverse Relationship
Interest rates and bond prices have an inverse relationship. In other words, when one goes up, the other goes down. For example, when the European Central Bank (ECB) increases interest rates, older bonds that were issued before the increase may become less valuable. That’s because their coupons are lower than what is currently on offer after the increase in rates. The price of those bonds may trade at a discount to par.
Likewise, when the ECB reduces interest rates, older bonds that were issued before that reduction may become more valuable. That’s because their coupons are greater than what is currently on offer after the reduction in rates. The price of those bonds may trade at a premium to par.
Key Insight:
Duration
How sensitive a bond’s price is to changing interest rates is estimated using what’s known as duration. A bond’s duration is a quantifiable metric for interest rate risk and shouldn’t be confused with a bond’s maturity date. The higher a bond’s duration, the more its price will fall as interest rates rise. Conversely, as interest rates fall, the more its price will increase. Duration is measured in years, so a bond with a duration of 10 years is twice as volatile as a bond with a duration of 5 years.
As a rule of thumb, bond investors who want to avoid large fluctuations in the value of their bond holdings should stick to bonds with short durations. Investors who are comfortable with large fluctuations, or investors who expect interest rates to fall in the future, should focus on bonds with long durations.
Key Insight: High-coupon bonds will have lower durations than low-coupon bonds. That means high-coupon bonds are less price sensitive to changes in interest rates than low-coupon bonds. Here’s why:
Credit Rating & Bond Prices
Interest rates aren’t the only factor which can cause a bond’s price to change. For example, an upgrade in the credit rating of the bond issuer can result in bonds trading at a premium. A downgrade in a credit rating can result in bonds trading at a discount.
Free Weekly Update
Free Weekly Update
Clear, practical insights on savings, pensions, banking, insurance, tax, and more.
Bond Yield
When the price of a bond changes, so too will its yield. Say an investor purchases a bond with a face value of €1,000 and a coupon of 4%. That investor will earn €40 in interest per year from an investment of €1,000. Therefore, the bond yield is equal to the coupon of 4%.
However, say the market price of the bond falls to €900. If you were to buy that bond from the original investor, or from any other investor on the secondary market, you would receive €40 in interest per year from an investment of €900. Therefore, the bond yield for you, as the purchasing investor, is actually 4.44% even though the bond coupon is fixed at 4%.
Likewise, if you purchased the bond for €1,100, the bond yield would fall to 3.64%. So, as bond prices fall, bond yields rise and as bond prices rise, bond yields fall.
Key Insight: Bond yields change when investors start to demand a higher or lower rate of return for investing in a given bond. This could be for a number of reasons including:
- Changes in the risk-free rate of return
- Changes in inflation expectations
- Changes in the likelihood of default
- Changes in market liquidity
- Changes in duration risk
While the coupon can’t be changed, the bond yield can. This is achieved by driving the bond price up or down. If investors demand a higher return, the bond price will fall. If investors are satisfied with a lower return, the bond price will rise.
Yield to Maturity (YTM)
Yield to maturity (YTM) – not to be confused with a bond’s yield, is the expected annual return from a bond’s future cashflows. This includes the coupon payments made over the life of the bond and the repayment of the bond at maturity. YTM accounts for both the time value of money and the bond’s current price. It assumes that the investor holds the bond until maturity and reinvests any interest at the same rate.
The higher the YTM, the higher the expected return on the bond. Higher YTMs may signal higher risk, which may be the case if there are concerns about the creditworthiness of the bond issuer.
Key Insight: Yield to maturity is arguably the most important metric when investing in bonds. It’s the best way for investors to make like-for-like comparisons between bonds, no matter their price, coupon or maturity date. It can also be used to compare against inflation, savings account AERs and stock returns to evaluate the competitiveness of a bond’s return.
Yield to Maturity Illustrated
Let’s look at a simple example. Imagine we’re analysing three bonds. Each bond has a face value of €1,000 with one year left until maturity. We’ll assume that each bond offers a different coupon, with different market prices.
| Coupon | Market Price | Annual Interest | Capital Gain/(Loss) at Maturity | Profit | Yield to Maturity |
|---|---|---|---|---|---|
| 0% | €952.38 | €0 | €47.62 | €47.62 | 5% |
| 5% | €1,000 | €50 | €0 | €50 | 5% |
| 10% | €1,047.62 | €100 | (€47.62) | €52.38 | 5% |
Despite the fact that the market price and coupon of the bonds are all different, the yields to maturity are identical. We can prove this by dividing the profit by the market price and multiplying by 100:
- 0% Bond: (€47.62 ÷ €952.38) x 100 = 5% YTM
- 5% Bond: (€50 ÷ €1,000) x 100 = 5% YTM
- 10% Bond: (€52.38 ÷ €1,047.62) x 100 = 5% YTM
If the YTMs are identical, we should be indifferent to which bond we select from a mathematical perspective. In practice, however, how a bond delivers its return to an investor matters for both cashflow management and taxation.
Why The Source of Bond Returns Matters
While the YTM tells you your gross return, it’s your net return after-tax that matters most. How much tax you pay depends on how your bond returns are earned. When comparing YTMs on different bonds, you need to factor in the tax rate that will apply to each yield depending on how it’s paid out.
Using our previous example, we can see how an investor in each bond would earn their returns from the date of investment up until the maturity date:
0% Bond: The investor will have a capital gain of €47.62. That’s because the bond will mature at its face value of €1,000, which is higher than the €952.38 that the investor paid for it.
5% Bond: The investor will earn interest income of €50. That comes from the 5% coupon. There will be no capital gain or loss as the market price paid by the investor equals the face value.
10% Bond: The investor will have a capital loss of -€47.62 and interest income of €100. The income comes from the 10% coupon. The capital loss is due to the bond maturing at €1,000, lower than the €1,047.62 that the investor paid for it. The net return is €52.38.
Key Insight: Bond investors need to consider whether they’d prefer to receive the bulk of their returns as income or capital gains. There are pros and cons to both. Income is paid frequently, but it’s liable to income tax, USC and PRSI which may be as high as 52.2%. Capital gains come late at maturity, but are liable to CGT at 33%. Irish government bonds are exempt from CGT.
High income earners may choose capital gains over income to save on tax. Retirees may choose income over capital gains to have a regular income. Other investors may choose a higher income to realise a capital loss at maturity. That loss could be used against capital gains to reduce CGT.
Bonds Aren’t Risk-Free
One of the biggest misconceptions about bonds is that they’re always ‘low risk’. They’re not. For example, when the European Central Bank (ECB) started increasing euro area rates in 2022 to tackle inflation, bond prices fell sharply. When rates rise, bond prices fall. This may not be an issue if you plan on holding your bonds to maturity.
Key Insight: One of the ways that bonds differ to stocks is that losses on bonds can be avoided by holding the bond until maturity, provided the issuer doesn’t default.
For example, imagine you bought a bond at par. If that bond later trades at a discount to par, the unrealised loss shouldn’t concern you if your plan is to hold the bond until maturity. At maturity, you’ll receive a repayment of your initial investment, provided the issuer doesn’t default.
In fact, because bond prices equal the present value of future bond cashflows, the market price of the bond will naturally return to par as the bond approaches maturity. This is known as pull to par. That’s why you’ll see bonds that are close to maturity trading at near 100.
But there are cases where bondholders can’t hold their bonds until maturity. If that’s the case, and the bond is trading at a discount to its purchase price, real losses can arise.
In 2023, a US bank called Silicon Valley Bank (SVB) collapsed. At the time, it was larger than AIB, Bank of Ireland and PTSB. By the end of 2022, SVB had invested over $91 billion in long-term bonds. Due to rising rates, the value of SVB’s unrealised bond losses by September 2022 amounted to $16 billion. This wouldn’t be a problem if SVB could hold the bonds until maturity.
However, the bank had a highly concentrated depositor base – startup companies with hundreds of millions of dollars on deposit. On paper, only $250,000 of each company’s deposits would be guaranteed by the FDIC if anything happened to the bank. The market caught wind of SVB's bond losses and panic ensued. $42 billion worth of attempted withdrawals in one day – a bank run.
SVB didn’t have the cash. They would be forced to start selling their long-term bonds in order to meet withdrawals. Selling turns those unrealised losses into real losses. In the space of 24 hours, SVB had a negative cash balance of nearly $1 billion and the FDIC pulled the plug. That's duration at work. Long-term, low coupon bonds are highly sensitive to changing interest rates. Always match the maturity date of a bond investment to when you might need the cash.
Risks of Bond Investing
There are four main risks of bond investing:
Credit Risk
The bond issuer might fail to pay interest or return your investment.
Interest Rate Risk
Rising rates may cause bond prices to fall.
Liquidity Risk
Where you can’t buy or sell a bond quickly without taking a hit on the price.
Inflation Risk
Bond returns may not keep up with the annual rate of inflation, leading to negative real returns.
How To Invest In Bonds in Ireland
Irish investors will need to download an investment app, also known as an online broker, to invest in bonds. You can find the right investing platform for your needs by using our comparison tool.
Our Recommendation → Trade Republic
- Direct bond investing
- Invest as little as €1
- Zero commissions
Direct Bond Investing
Direct bond investing is where you purchase individual, existing bonds from other investors on the secondary market. It isn’t a feature that’s commonly offered, but investment platforms like Trade Republic, DEGIRO and Interactive Brokers do make it available to Irish investors.
Key Insight: When you invest in bonds using an investing platform, you’re actually trading on the secondary bond market. That means you’re purchasing the rights to receive the bond coupon plus repayment at maturity from another investor who previously held those rights. You're not directly lending to the bond issuer, that's done on the primary bond market.
There are a couple of important factors to keep in mind when investing directly in bonds as it’s quite different from investing in stocks:
One of the challenges that retail investors have historically faced is finding bonds that are liquid. In other words, finding bonds that can easily be sold without having to sacrifice on price. Certain investing platforms may only allow you to directly invest in bonds that have met their own internal requirements for liquidity.
Placing a bond order is different to placing a stock order. You’re not buying shares, you’re buying debt. You need to specify how much of the bond’s par value you want to buy. This is how much you want to receive back once the bond matures.
What’s important here is the interaction between a bond’s denomination and its lot size.
Denomination: The smallest piece of debt issued by the borrower.
Lot size: The smallest amount of par value that you can trade in.
The minimum par value you can purchase is almost always the greater of the denomination and the lot size. For example, say a bond has a denomination of 1,000 and a lot size of 1,000. An investor will only be able to purchase par in multiples of the lot size i.e. multiples of 1,000.
If the investor decided to purchase 1,000 worth of par, how much money leaves their account will depend on the market price. Remember, bond market prices are quoted as a percentage of face value. If the ask price for the bond was 65 (i.e. 65% of par), then purchasing 1,000 worth of par would cost the investor €650 plus broker fees. They would get €1,000 back at maturity.
Key Insight: When you invest in a bond you will pay the dirty price. This is the market price of the bond plus any accrued interest. Accrued interest is the interest that’s accumulated on the bond since the last coupon payment. You pay the seller this amount and recoup it when the next coupon payment is made. The quoted market price is referred to as the clean price.
Certain brokers may offer fractional bond investing. This means that you can invest as little as €1 in bonds without needing to worry about bond denominations or lot sizes. There are two ways that this is done:
1. Invest By Amount
You invest any amount at the current market price. That means you don’t enter how much par value you want at maturity. You enter the euro amount you want to invest at the current market price.
If the market price is above or under par, you’ll receive a different amount back at the date of maturity than what was originally invested. For example, say you invested exactly €1 into a bond that had a market price of 80. You’d buy €1.25 worth of par value at maturity.
2. Invest By Par
You specify how much par value you want at maturity without having to meet the minimum lot size. For instance, say you were looking at a bond that had a lot size of 1,000 and a market price of 90. With fractional investing, you could specify that you only want €1 worth of par value at maturity, ignoring the lot size of 1,000. That would cost €0.90 plus any fees and accrued interest.
Key Insight: Brokers are able to offer fractional bond investing by buying whole bonds on the market and slicing them up for sale to their users. You hold a contractual claim against the broker for your portion of the bond.
Did You Know?: Fractional bond investing is usually only available if your order type is set to market order. A market order will be executed immediately at the best available price. That price may not be favourable if the bid/ask spread is wide due to low liquidity. Setting a limit order allows you to specify the maximum price that you’re willing to pay for the bond (i.e. the percentage of par). The downside is that you’ll need to meet the denomination and lot size requirements, often €1,000 or more.
When selling a bond before its maturity, there are two important things to remember:
- If the bond’s yield is higher than when you bought it, you’ll be selling at a loss.
- If the bond’s yield is lower than when you bought it, you’ll be selling at a gain.
Bond ETFs - Indirect Bond Investing
Indirect bond investing is widely available. All major investing apps will let you invest in exchange-traded funds (ETFs) that either actively select government and corporate bonds, or passively track a bond index. In both cases, you don’t own the bonds directly, you own shares in a fund that manages a bond portfolio.
The process of buying shares in a bond ETF using an investment platform is no different than buying shares in a stock ETF. However, the research that’s required prior to investing is. In the factsheet of a bond ETF, you’ll commonly see:
Average Weighted Maturity: The average time until the underlying bonds mature, with each bond weighted by its percentage of total assets.
Effective Duration: A measure of the ETF’s interest rate sensitivity, with longer durations being more sensitive to shifts in interest rates.
Weighted Average YTM: The average yield to maturity of each bond held by the fund, weighted by their percentage of total assets.
These are not terms that you’ll come across in the factsheet of an equity ETF. Still, they are key metrics that will determine whether the ETF is suitable for you. That’s on top of the usual considerations like index, domicile, use of income, currency risk, replication strategy and TER. These extra factors make bond ETFs more complex than stock ETFs.
Not sure what an ETF is? No problem, we’ve got a complete guide that’ll tell you everything you need to know.
How To Research Bonds
When researching bonds to invest in using an online investment platform, there are a number of things to look out for:
Duration
Some brokers will allow you to filter bonds by duration. This could vary from as low as 1-6 months all the way up to more than 10 years. Bear in mind that ‘more than 10 years’ is a large category. It can go as far as 100 years in the rare case of Austria, which famously issued 100 year bonds back in 2017.
The higher a bond’s duration, the more its price will fall as interest rates rise, and the more its price will rise as interest rates fall. You can set this filter based on what you’re looking for.
Bond Type
Most platforms will allow you to filter bonds by type: corporate or government. You may be able to refine your filter to search for corporate bonds in certain industries as well as corporate and government bonds issued in a certain country.
Yield to Maturity
When looking for the Yield to Maturity (YTM), keep in mind that some brokers will display this as the annual return of the bond.
Return Breakdown
Certain trading platforms will provide you with a breakdown of how the bond’s return will be earned over time. This is helpful for establishing the split between capital and income returns.
Other Information
Other key information includes the frequency of interest, the next interest payment date, the bid/ask spread, the ISIN and the bond issuer.
Key Insight: Before you invest in any bond, make sure that you check the credit rating of the issuer. It’s crucial that the bonds you're investing in align with your attitude towards and tolerance for risk. Simply type in the bond issuer's name followed by “credit rating” on Google.
Frequently Asked Questions
Most investors should invest in a bond ETF. They offer diversification, investing in thousands of bonds instead of one. They’re professionally managed, which is recommended given the complex nature of these funds. Plus, you can invest in bond ETFs with as little as €1 and the shares are easier to buy and sell.
Bond ETFs pay dividends. These payments are funded by the interest that the fund earns on its bond investments.
Convexity shows how a bond’s duration changes as interest rates move. High convexity suggests that as rates fall, bond prices will increase by more than they’ll decrease when rates rise.
Callable bonds give the issuer the right, but not the obligation, to pay back their debt earlier than the maturity date. If interest rates fall, the issuer could call their bonds and refinance the debt at a lower rate, saving on interest expense. Callable bonds tend to have higher coupons.
Yield to Worst (YTW) is the lowest yield an investor could receive without a default, accounting for call dates and any other factors that could impact a bond’s return.
Reinvestment risk is the risk of earning a lower rate of return on reinvested interest than the original investment. Yield to maturity assumes that any interest received from a bond is reinvested at the same rate. Reinvestment risk is the chance that this won’t happen. The higher the coupon and the longer the maturity, the greater the risk.
No, most bond ETFs don’t have a maturity date. Instead, they’ll typically maintain a target weighted average maturity (WAM) by rebalancing the fund’s holdings over time. If you have a specific date for needing cash, you could be better off investing in a target maturity bond ETF or a single bond.
Inflation-linked bonds (ILBs), also known as index-linked bonds, are designed to adjust their principal value and interest payments in line with inflation. In Ireland, the NTMA has previously issued Irish ILBs tied to the Eurostat Harmonised Index of Consumer Prices (HICP) for Ireland.
Floating-rate bonds have variable coupons that can go up or down depending on the performance of a benchmark like the EURIBOR. You can buy shares in a Passive Floating Rate Notes ETF (FRN ETF) to invest in hundreds of variable rate bonds simultaneously.
Convertible bonds are corporate bonds that give investors the option, but not the obligation, to convert their investment into shares of the issuing company. Convertible bonds typically offer a lower coupon than traditional bonds.
Mortgage-backed securities (MBS) are bond-like investments that pay out a portion of the principal and interest payments made by homeowners on a pool of mortgages. They allow investors to access the returns of the mortgage market without originating the loans themselves.
Find the Right Investment App
Compare the most popular investment apps available to Irish investors by fees, features and investment selection to choose the platform that's right for you.
