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Over the past year, many companies operating in Lithuania have distributed their bonds, and their supposedly low risk and relatively attractive returns have attracted even first-time investors. How do bonds differ from stocks, what are their advantages and disadvantages, says Mantas Skardžius, senior portfolio manager at Luminor Bank.
What are bonds?
A bond is a type of debt. When buying a bond, the investor lends money to its issuer, known as the issuer, and in return receives interest for the term of the bond. At the end, the bond issuer returns the amount for which the bond was purchased.
“Simply put, the bond issuer needs money for expansion, large projects, etc. Companies can also borrow money from banks – but if the financing provided is not enough, companies issue bonds and sell them to investors. That’s why they’re called bonds,” explains the Luminor Bank expert.
How are bonds different from stocks?
The fundamental difference between bonds and stocks is that bonds are a loan and stocks are property, says M. Skardžius.
“The holder of the bond lends money to its issuer and, to use an everyday example, in his role is more like a bank that grants the loan.” And here the owner of the share is the owner of a part of the company, takes part in the election of the company’s board of directors and makes other important decisions,” the expert clarifies.
In this case, according to M. Skardžius, it is usually better to be a bond owner than a shareholder – if the company that issued the bonds gets into financial difficulties, the bond owners have priority in the creditor line over the company’s shareholders.
“If the company fails to fulfill its obligations, the holder of the bonds also has the right to file a bankruptcy petition against the company. Therefore, bonds are considered a less risky and safe investment compared to stocks,” says the senior portfolio manager of Luminor Bank.
What types of bonds are there?
Bonds can be classified according to several criteria: insurance, type of income, maturity and others. One of the most important and common classification methods is to divide bonds according to their origin into public and private corporate bonds.
“Government bonds are issued by almost all countries in the world and are considered one of the safest, since the theoretical possibility of government bankruptcy is low, unlike companies. However, for this reason they are often less profitable,” says M. Skardžius.
Bonds from private companies are considered riskier than government bonds, although the actual risk depends on the company in question, says the expert. This means their potential profitability is also higher.
What are bond yields and why are they so popular now?
M. Skardžius points out that the profitability of bonds is assessed taking into account the interest rate paid, which may depend on the demand for the bonds themselves, credit risk, inflation and other factors.
Profitability is also determined by the term of the bond – if the bond has a long maturity, the interest income is usually higher than on short-term bonds, but there is also a higher risk.
“It is particularly important to consider the current economic environment. When interest rates are low, the stock market is more attractive. However, if interest rates are relatively high – and have been for more than a year – the attractiveness of bonds increases. “This is, among other things, because companies are more inclined to take out loans by issuing bonds due to the prevailing high costs of borrowing from banks,” explains the Luminor expert.
According to him, if necessary, the purchased bonds can be sold on the secondary market before the maturity date. In the secondary market, the price of bonds depends on the prevailing interest rate, so even bonds sold before the maturity date can earn a return.
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