Which type of bonds to choose?
Bonds are loans from governments or organizations, they pay you a price in the form of coupon interest. What is nice is that bonds protect your portfolio against sudden price drops. There are different ways to invest in bonds . As an investor, it is best to spread your risks over different investment options because the different investment forms have different risks . In this article you can read more about the best bond choice for you. In addition, it will also discuss, for example, the costs you may encounter and the return you can achieve.
Investors want certainty in uncertain periods, which increases the demand for (government) bonds. This phenomenon is also called ‘the flight to quality’. Is the economy going in the right direction? Then the demand decreases and there is a rising interest rate. You can include bonds in your portfolio in three different ways: individually, via a bond fund or by purchasing a bond ETF. Now the question is: what is the best choice for an average private Dutch investor?
The cost of bonds
The basis is important. If you subtract the costs from the revenues, you get the profit/return. That is why it is important to pay close attention to the costs when choosing a bond. Small differences that do not seem so important at first can still have an effect on your investments in the long term. The compound interest can show large differences, this is certainly the case with bonds that normally show lower returns than shares.
A small difference in price is called the ‘Total Expense Ratio’ or TER, this can already significantly reduce your return. For example, if you look at the return of the Think iBoxx Corporate Bond (UCITS ETF), the return in 3 months is -4.29% with a TER of 0.15%. You can therefore imagine what the effect would be if you had a TER of 1%.
Buying individual bonds is often less accessible than the other options. The minimum investment for a bond often starts at €1,000, but is much more often €10,000 or €100,000. As a result, you may find this a less accessible option as an investor. Not everyone has this amount, and applying spreads with individual positions within the fixed-income part is more difficult to do.
The proceeds of bonds
Active fund houses claim that the higher costs incurred are due to research efforts. These are used to achieve a higher return. This is currently monitored by the SPIVA. This organisation has been conducting research into the performance of various (bond) funds for many years, in order to compare these results with the corresponding index.
The trend resulting from the figures for the American market is recognisable compared to the European market. Despite the fact that figures for the European market are missing. A large majority of active fund managers deliver lower returns than the index, the percentage of which increases as the period becomes longer. This results in no question of an unlucky year, but a fixed pattern of underperformance. Morningstar, the agency that researches funds, published the results of a similar study in 2018. In this report, researchers note that a majority of active fund managers often do not contribute sufficiently to bond selection. On the other hand, they do manage to get by in bond categories. For example, bond categories include ‘Emerging Market Debt’ or ‘High Yield’.
Morningstar researchers also showed that for more than 80% of active bond funds, the cost factor was the main reason for underperforming the index.
The riskiness and diversification of bonds
It is wise to choose bonds if you want to limit the risk of your other investments. Within these categories, you can also choose to diversify, because you have a more secure position by distributing your bonds. By selecting, managers of active funds add theoretical value and that investment pays off. Because there are fewer positions, the values are much more concentrated, which means that the flexibility of these funds also increases. As an investor, you buy a bond to limit fluctuations in the values. It is important to pay attention to the function that bonds have for you. A passive solution is often better in theory, think of an ETF .
Marketability of bonds
As an investor, there are often two solutions left; the bond index fund or the bond ETF. The similarities between these two investment products are strong because they both follow an index . However, they also differ in an important aspect; tradability. Because an ETF can be bought and sold continuously, there are certain catches. Constant trading is unwise. Apart from this, you can, for example, decide in the morning to raise the share of your investments to a higher level, which strengthens the basis of your portfolio. But suppose your central bank decides later in the day to lower the interest rate, then you can immediately trade your purchased products again.
Besides the fact that this is a pleasant prospect, there is also something else. Just like with a share, it is possible to indicate a limit price, with which you make clear what you want to buy and sell. Note that this is not the case with a bond fund; there, buying or selling can only be done once a day at the current price at that moment. Think about this before you choose one of the bonds.
A fair bond price
The operation of the primary and secondary markets provides another advantage in addition to the liquidity in the ETF market. The bond market is less liquid than the stock market, which can sometimes make it difficult to determine the price of a bond . The reason for this is the lack of a central market. To solve this, the Authorised Participant (AP) and the other participants combine supply and demand within the secondary market. The resulting result is a market where the value of your bonds can be calculated on a constant basis. This gives you more certainty that you are really paying a fair price for your ETF bonds.
The conclusion
If you look at the costs, the yield, the tradability of bonds and the most important characteristics of the other investment products, you can best choose the ETF as a fixed interest component within your investments. The most important reasons for this are the characteristics of ETFs: cheaper, more widely spread and always tradable. Bonds have an equal value to ETFs due to the lower costs, although the latter has a stronger position if you are an investor. Of course, as an investor you have to look for exceptions, but in 9 out of 10 cases you can assume that you can trade better with an ETF.
Compare brokers and start investing in bonds
After reading this article about choosing a bond, are you excited about investing in bonds? Compare brokers with a bond offer and find the broker that suits you best!