What
are Bonds?
What are Bonds? Is it worthwhile investing in Bonds? How risky is it? What are the returns one can expect from investment in Bonds?
A bond is a debt security that is similar to an I.O.U. Unlike stocks, bonds do not give investors ownership in a company. A bond is a loan from an investor to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay the investor a specified rate of interest during the life of the bond and repay the face value of the bond (the principal) when it “matures,” or becomes due. Every bond has a fixed maturity date ranging from a few months to a few decades. When a bond matures the borrower must pay the lender the full value of the bond.
There are many different types of bonds including U.S. government securities, municipal bonds, corporate bonds, federal agency securities and foreign government bonds.
The amount of interest that different bonds pay is expressed as a percentage and is called the bond yield and depends on a variety of factors. These include other interest rates, inflation, the risk that the borrower will default on the loan, and attributes of the bond such as whether or not the bond can be called or converted. A bond can be priced at par, premium or discount depending on the difference between required yield and its interest rate. If the interest rate and the required yield are identical, the bond will be priced at par. If a bond pays a lower interest than the market’s required rate of return, the bond is sold at a discount. If the bond pays a higher interest, it will be sold at a premium.
A bond investment has three sources of returns:
§ Income from Interest – This is the amount of interest that the issuer will pay periodically to the investor. It is calculated based on fixed or floating rates methods. The rates and frequency of payments will be declared when the bond is issued.
§ Repayment of Principal - When a bond reaches its maturity date, the issuer will return the principal loan amount to the bondholder.
§ Capital gain - Capital gain occurs when a bond is sold at a profit and it can take place during the life of the bond or at the maturity.
Advantages of bond investment:
§ Regular interest payments: One of the major advantages of a bond is the regular payment of interest. Because of this feature, bonds can be a great income-generating vehicle.
§ Repayment of principal: At its maturity date, the principal amount has to be repaid to the investor. This feature allows many people to preserve and increase their capital.
§ Less volatility: Compared to stocks, Bonds are less volatile thus offering greater protection from stock market downturns.
Risks associated with bond investment:
§ Inflation risk is the single most important risk factor to take into consideration when buying bonds. The prices of all bonds fluctuate with inflation.
Many personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages depending upon individual circumstances and objectives.
