Want to Invest in Bonds? Learn the Basics of Bonds

What are Bonds?

You must have heard about the government floating bonds to raise money for development or read about the bond market in your daily newspapers. However, if you are not actually sure what bonds are or how they work as an investment option then you are at the right place.

A bond is a form of investment where the investor gives loans to the Government, a corporation, federal agency or any other organization. As a result, bonds are at times called debt securities. Since the borrower (bond issuer) knows you are not going to lend them your hard-earned dollars without compensation, they (bond issuer) enters into a legal contract in which you (the bondholder) is paid some interest.

The agreement also compels the bond issuer to repay you all the money loaned at the maturity date of the bond. Most bonds have a specifically set maturity date - on this date, the bond must be paid back per value. However, the issuer has a right to redeem (to call bond) some of the bonds before the expiry of the fixed period subject to bond protection rules.
Bonds are fixed-income securities since you are paid interest on a regular, preset rate – a coupon rate – determined during bond issue.

Having a clear understanding of the bond basics is vital before deciding on this investment option. The more you know, the lower the chances of making a regrettable decision.

Bond Maturity and Callable Bonds

The time in years a bond takes before reaching its maturity is usually set during issuance. The maturity period can be anything between 1 day and 100 years. The bonds are usually categorized into short-term bonds (1 - 3 years), medium term bonds (4-10 years) and long-term bonds which take 10 years to mature. The bond issuer fulfills its debt obligation by paying the principal (original sum loaned) plus the final interest on the bond maturity date.

On the other hand, some bonds have call provision which allows the issuer to retire the bond earlier than the maturity date. It follows that not all bonds will reach their maturity, even if you wanted them to. It is therefore necessary to check if the bond the bond you are buying has a call provision and examine how this may affect your investment plan. The provisions are usually documented on indenture and the bond’s prospectus – both are documents explaining the bond’s terms and conditions.  Nevertheless, you are usually entitled to some bond protection during the initial periods of the bond’s life. During the bond protection period, the issuer has no right to call the bond. This period varies from bond to bond so be sure to read all the provisions before putting pen to paper.

Bond Prices

Borrowers usually issue bonds in multiples of $1,000 – aka per value or a bond’s face. However, the bond’s price often fluctuates below or above par - subject to market forces. Selling a bond before maturity can either result in earning more or less than the principal plus the total interest up to the maturity date. This is because bond prices are not fixed and fluctuates due to their establishment in the secondary market.

There are many reasons why a bond value can be below or above the par value: adjustment of interest rates, whether or not the bond has been called or is likely to be called, demand and supply, variation in creditworthiness of the bond issuer, changes in prevailing interest rates in the market, and lots other factors. A bond trading above par is said to be trading at a premium whereas those trading below par are said to be trading at a discount. For instance, if the bond you intend to purchase has a fixed interest-rate of 7%, and a similar-quality new bond is being sold at 5%, you will probably pay more than the par value of the bond you want to buy, because you will get more interest income than the current 5% being attached to similar-quality bonds.

Bonds Vs Stocks

Just like any other investment product, bonds generate fluctuating returns year in year out. Stocks held for a long period have often outperformed bonds by a margin of nearly 2 to 1 since 1926. However, a tradeoff exists: the performance edge of stocks has come with knocks and uncertainty. But bonds – even the popular U.S. Treasury bills – will also have their ups and downs.

For smart investor, in pursuit of stable investment, it is generally advisable to adjust your portfolio to comprise a larger percentage of bonds – this is partly because stocks and bonds are inclined to move in different directions.  That is to say, when stock prices fall, bond interest rates often rise and vice versa.  Coming up with the right mix will utterly depends on you – your age, pecuniary objectives and tolerance to risking more for greater return potential.

Return read the next post on how to buy and sell bonds.