Most investment media talk a lot about stocks, so it might surprise you to know that the bonds market is bigger than the stocks market. As a first question, you may ask why might you consider investing in bonds?
As a simple answer, if you don’t have bonds you may be missing out on a key asset that can help reduce your investment risk while improving your long term returns.
In this post, I will try to answer most of all questions on bonds and to help you decide on what type of bonds could be best for you.
What are bonds?
Whether you realize it or not you have likely dealt with bonds in one form or another.
A first definition that you can find on the web is that a bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically private or governmental).
Okey, I’ll explain it in a simpler way!
Corporations and governments sometimes need extra cash and they’ll generally issue bonds to helping to get a loan from investors. These bonds are very specific when companies or other entities need to raise money for new investments to maintain their current go ongoing operations or just refinance debts they may decide to issue bonds directly to investors instead of getting a loan from a bank.
The issuer of the bond contractually states what interest will be paid and at what date the initial amount of money or the principal that you loaned them will need to be returned for bonds.
The interest rate has a special name called the coupon rate which dates back to when bonds have actual coupons that you would rip off them in exchange for your interest payments.
Most bonds share some common characteristics:
Face value of the bond
According to Investopedia.com, A bond’s face value is the amount the issuer provides to the bondholder, once maturity is reached.
it’s also the reference amount the bond issuer uses when calculating interest payments.
so, for example, say an investor purchases a bond at a premium of 1090$ and another purchased the exact same bond at a discount of 980 dollars. when the bond matures both investors will receive the $1,000 face value of the bond.
At the maturity date, the bond will be worth 1000$ but before that time the bond might be trading in the market above or below the face value of a thousand dollars so by and below that face value is called buying at a discount and by an above that face values called buying a premium.
The coupon rate
the coupon rate is the rate of interest the bond issuer will pay on the face value of the bond expressed as a percentage so, for example, a 5% coupon rate means that bondholders receive 5% times 1000 or 50$ every year.
The coupon date
coupon dates are the dates on which the bond issuer will make those interest payments typical intervals are annual or semiannual.
coupon payments maturity date is the date on which the bond will mature and the bond issuer will pay the bondholder the face value of the bond.
The issue price of bonds
The issue price is the price at which the bond issuer originally sells the bonds. most of the time the issue price is at face value there are two characteristics of a bond that are the main determinants of the risk of a bond: credit quality and duration.
Credit quality and duration
Credit quality is a measure of how likely the bondholder will be to repay the bond in full.
Duration is the length of time between now and the maturity date when the bond will be paid back.
Companies with a poorer credit rating and have a higher risk of default generally see their bonds trade at a discount because there’s more risk as to if whether the bondholders will actually get their full money back at maturity.
High-quality companies or government bonds which have a very high likelihood of being paid back in full tend to have lower interest rates than these more risky bonds.
As for the duration, bond maturities can vary from as short as a single day – as long as over 30 years. The longer the bond maturity or duration the greater chance is that you’ll see adverse effects this is why longer duration bonds tend to have higher interest rates than shorter-duration bonds.
Investing in bonds? be aware of inflation!
Another key risk that bondholders particularly need to be aware of is inflation. It is the mortal enemy of bondholders because it directly eats into the real value of the coupon interest payments that you’re receiving.
If a bond has a coupon rate of 5% and you bought it at par or meaning than face value then you’re getting a 5% nominal return. If inflation is 3% per year, that 5% return is really just a 2% real return.
If the inflation rises to 5% per year you’ve effectively wiped out all of your interest gains from the bond.
Predicting inflation rates is very difficult to do and it’s one of the reasons why there’s more risk involved with longer duration bonds
Read also : The difference between bonds and stocks
The different types of bonds
As I mentioned earlier, bonds can be issued both by companies and the government, but there are some differences between each. The bonds issued by companies are called corporate bonds and they typically have higher interest rates than government bonds.
US Treasury bonds are issued by the United States government and have durations from 10 to 30 years.
Medium duration bonds from the US government are called Treasury notes and can range from duration from 1 year to 10 years.
Treasury bills are bonds with less than one year of maturity, collectively these are called Treasuries and often are have the lowest interest rate of bonds and are referred to sometimes as the risk-free interest rate.
Municipal bonds are offered by states and municipalities or local governments at least in the United States. one benefit of municipal bonds is that if you buy bonds within your municipality or state they can be exempt from taxes for this reason.
Given two bonds of the same credit quality and duration, if one is a municipal bond versus a corporate bond, the municipal bond will likely have a lower interest rate because of its tax advantages.
There are a few variations and bond types that you should be aware of:
One of these is zero-coupon bonds that do not pay any interest at all. They are instead issued at a discount which will eventually converge to their face value upon maturity. the annualized yield you’d get from a zero-coupon bond would actually be very similar to that of a coupon bond with similar credit quality and duration.
Another type of unique bond is something called a convertible bond.
These convertible bonds come with a call option that allows bondholders to convert their debt into stock if the stock price rises enough to make that an attractive option. In addition, some bonds are callable, meaning the issuer can call back the bond from bondholders if interest rates drop significantly.
Read also : The difference between bonds and stocks