Investing in Bonds

A bond is like a loan or IOU. It is a negotiable certificate which acknowledges that the issuer of the bond is indebted to the holder of the bond. In other words, it is a debt security, in which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (also known as the coupon) and to repay the principal at a later date, called maturity. Usually the bond contract promises to repay borrowed money with interest at fixed intervals (semiannual, annual, and sometimes monthly).

Bonds help the borrower bringing external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

Bonds vs. Stocks

In order to understand bonds better, let’s compare them to stocks. Bonds and stocks are both considered securities; however there is a major difference between the two. The stockholders have an equity stake in the company (in other words they are owners), while bondholders have a creditor stake in the company (they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, while stocks may be outstanding indefinitely.

Bonds are issued to investors by public authorities, credit institutions, and companies. Government bonds are usually issued by auctions, called a public sale.

Before you invest in bonds, you need to learn some of the most important features of a bond:

  1. Principal: the amount on which the bond issuer pays interest, and which has to be repaid at the end of the term.
  2. Maturity: the bond issuer has to repay the nominal amount on the Maturity date. The maturity can be any length of time but most bonds have a term of up to thirty years. In the market for U.S. Treasury securities, there are three groups of bond maturities: short term (bills): 1-5 year; medium term (notes):6-12 years; long term (bonds): +12 years.
  3. Coupon: the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. Coupons can be paid at different frequencies, generally semi-annual, i.e. every 6 months, or annual.
  4. Yield: the rate of return received from investing in the bond. To measure it simply use the current yield, which is (annual interest payment / clean price).
  5. Credit Quality: refers to the probability that the bondholders will receive the amounts promised at the due dates.
  6. Price: influenced by the above mentioned factors like maturity, quality, interest rates, and demand for the bond.

Risks in Bonds

As a general rule, to earn higher returns, you have to take greater risks. Conversely, the least risky an investment is, the lower the returns. The bond market is no exception to this rule. Here is a comparison between risks and benefits:

Interest rate risk (when interest rates rise, bond prices fall)Bonds carry usually a promise of their issuer to return the face value of the security to the holder at maturity; stocks do not offer such guarantees.
Reinvestment risk (when interest rates are declining, investors have to reinvest their interest income and any return of principal)Bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these payments to shareholders.
Inflation risk (inflation causes the value of bonds to be worth less over time, especially with high inflation)Historically the bond market has been less vulnerable to price swings or volatility than the stock market.
Liquidity risk (while government bonds are not very hard to sell, corporate bonds are not so easy to liquidate. There is a risk that an investor might not be able to sell the corporate bonds quickly due to a thin market with few buyers and sellers for the bond.Bonds are historically less profitable but less risky as well compared to stocks.
Credit risk (Just like people who occasionally default on their loans or mortgages, some organizations which issue bonds occasionally default on their obligations. Which means the remaining value of your investment will be lost.Consistent Income (unlike stock dividends, coupon payments are consistently distributed at regular intervals)

Bonds may be one way of generating income for investors and may also help mitigate overall portfolio risk. However keep in mind the risks listed above. Do your homework before buying.

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