Investing in bonds is a way to diversify one’s portfolio while offering the potential to generate a regular and secure income stream, and protect against stock market volatility. This type of investment offers a number of advantages and is a key component of many investment strategies.
Bonds, in fact, are debt securities issued by governments, supranational entities, or corporations, and represent a loan made by the investor to the issuer in exchange for periodic interest payments and repayment of principal at maturity.
However, investment can be made “directly,” through the purchase of a single bond or a selection of bonds, or through passively managed funds (ETFs) or actively managed funds (bond funds).
1. The different types of bonds to invest in
Bonds provide a fixed income stream in the form of interest, which can be paid on a semiannual, annual, or maturity basis. This steady income stream is especially useful for investors who need regular income, such as retirees or those seeking to balance their portfolio with a stable income component.
The different types of bonds in which to invest directly:
- Government bonds (government securities). These are bonds issued by the Ministry of Finance on behalf of the state for the purpose of covering its debt or public deficit. The gain for those who own them can come either from the difference between the face value and the issue or purchase price, or through coupon payments. When the bond matures, the government repays the initial principal. In Italy, the most popular examples of government securities, or government bonds, are BOTs and BTps. Thus, BTp Italia, BTp Futura, BTp Valore, Zero-coupon Treasury Certificates (CTZs) and Certificates of Credit of the Treasury (CCTs) also fall into this category;
- Municipal bonds (Municipal Ordinary Bonds and Regional Ordinary Bonds). These are bonds issued by local governments (provinces and regions) and subordinated to the implementation of public works;
- Corporate bonds (corporate bonds). These are debt securities issued by private companies, such as banks, industrial or commercial companies. Unlike stocks, which represent a stake in the company’s venture capital, bonds do not provide voting rights at shareholder meetings;
- Supranational bonds. Bond securities issued by international organizations that cannot be identified with a single country (e.g., World Bank, European Investment Bank).
2. The advantages of investing in bonds
Predetermined income stream: bonds pay a contractually defined stream until maturity, while stock dividends are not as predictable. Bonds provide a more secure source of income therefore than stocks, which can be useful if a certain level of income is needed to meet regular payments.
Repayment of principal: bondholders will receive the face value of the bond at maturity, although this may be higher (if the investment was executed below par) or lower (if the investment was executed above par) than the purchase price.
Diversification: bonds can help diversify a portfolio in a major way-just think of the different types of issuers, available currencies, and varying maturities through which an efficient portfolio can be structured.
Low-risk investment: it is possible to greatly reduce the degree of risk, for example, by choosing government bonds, which are considered the safest instrument in the market. Although the risk of issuer default is always present, the probability that the government will fail to repay the principal and interest on the bonds is lower than if a company defaults.
3. Bond funds and bond ETFs
Bond ETFs are passively managed funds that invest in one or more bonds, such as government or corporate bonds, to replicate their yields.
Bond funds, on the other hand, have active management: the manager makes an initial product selection that may change over time depending on opportunities in the market.
In general, both instruments have advantages and disadvantages compared to buying securities directly.
ETFs, compared to funds, do not require the investor to pay a management fee to the manager. However, their function of merely replicating the returns of an index does not involve active selection of its component securities.
In contrast, funds provide greater reliability because of the expertise of the management team that performs bond picking (selection of specific bonds by the fund managers), but require higher costs from the investor.
Both instruments also have the following defects:
- Distributed income of varying amounts depending on the securities contained in the fund and absent in the ETF, which accumulates the income within the countervalue and does not distribute it;
- Continuity of life of the product, which therefore does not provide for maturity, and thus repayment of principal, except by selling it.
