In this overview, we will discuss such a popular investment instrument as bonds. Investors use bonds for preserving and increasing their capital.
What are bonds?
A bond is a debt security with fixed revenue, used by the state or companies for attracting money by borrowing it from investors (funds, companies, or individuals). Bonds are often issued for raising money for certain projects. In essence, a bond is a credit agreement for a certain period with a fixed size of interest.
Buying bonds, an investor provides the issuer of the bonds with a certain sum of money that the company will later use. In exchange, the issuer will pay off a certain interest on this sum during a set period, and when it is over, will pay back the whole sum. Unlike a shareholder, a bondholder normally has no share in the company, no right to participate in shareholders’ voting, or receive dividends.
Some bonds are rated by agencies, such as Moody’s, Standard & Poor's, to help investors make up their minds about their quality. Such ratings are used for estimating the probability of paying back the borrowed sum. Normally, ratings of bonds are of two types: credit rating (trustworthiness) and profitability rating.
Main characteristics of bonds
The main characteristics of bonds are:
- The Time of Maturity: it is the date when the issuer must pay back the borrowed sum. The term may vary from one to thirty years.
- Principal, or Face Value is the sum that will be paid to the investor before the Time of Maturity. It can be paid in parts.
- Coupon is the revenue that investors receive. It may be fixed or floating. Usually, the interest is paid by a schedule.
Normally, there are two types of markets for bonds – primary and secondary:
- Primary market is the one where issuers sell their bonds.
- Secondary market appears later when investors start selling their bonds to other investors. The price of bonds in the secondary market changes depending on supply and demand, interest and inflation, and also how many Coupon payments and time are left until the Time of Maturity.
The overall revenue from bonds consists of two parts: coupon revenue (from the interest paid) and discount revenue (from the difference between the sum of the bond purchase and redemption).
What types of bonds are there?
- Corporate bonds are debt instruments issued by a company for attracting capital for development, research, or the introduction of inventions. The interest received from corporate bonds is taxable. Simultaneously, the interest on corporate bonds is usually higher than on municipal or state bonds.
- Municipal (local) bonds are issued by cities, towns, regions, etc. to gather money for public projects, such as the construction of schools, hospitals, roads, etc. Unlike corporate bonds, the interest on local bonds is non-taxable.
- State (treasury) bonds are issued by the government of a country. As long as they are fully secured by the government, they are considered the most trustworthy bonds. However, the interest on state bonds is much lower than on corporate ones.
Advantages and drawbacks of bonds
The advantages of stocks are:
- Saving the capital. Bonds with a high rating are a more trustworthy instrument than stocks. They are less prone to market risks and help investors save their capital.
- Stable revenue. Bonds provide a fixed revenue received by a schedule as the Coupon.
- Diversification. Investments in bonds, stocks, or other assets will help create a balanced investment portfolio – profitable and stable.
The drawbacks would be:
- Relatively low profitability. Bonds are more trustworthy but less profitable than stocks or other financial instruments. If the inflation level is higher than the Coupon revenue received by the investor, the purchasing power of their capital will decrease.
- The risk of a change in the interest rate. When the interest rates of Central banks grow, the prices of bonds drop, and bonds that you are holding can also drop in price. The fluctuations in interest rates are the main causes of instability in the bond market.
- Credit, or investment, risk is the risk that the issuer will not pay the borrowed money back. Increased credit risk is characteristic of profitable bonds with a low rating.
Advice on investing in bonds
- Check the Time of Maturity, i.e. the date when your investments will fully come back to you. Before buying a bond, consider what term you are ready to invest in.
- Check the rating of the bonds. The rating represents their trustworthiness. The lower the rating, the higher the risk of default – you can lose your investments. AAA is the highest rating (by Standard & Poor's system). Bonds with the rating C and lower are considered unreliable, with a high risk of default.
- Study the service record of the issuer. Some history of the company may be useful when making up your mind whether to invest in the company or not.
- Choose a reliable broker. Make sure that it has a license and can be found in special ratings of brokers.
- Make up your mind about how much you are ready to risk. Bonds with a lower rating normally suggest higher profitability explained by the high risk level. More reliable bonds offer lower profitability. Try to find the golden mean.
- Make your approach balanced. Bonds can diversify your investment portfolio and balance investments in stocks and other assets.
- Study the commission fees and other expenses. If you invest in a bond fund, check the fees and the types of bonds present in the fund.
Bonds is a reliable instrument of the financial market with moderate profitability. Most often, investors use bonds for balancing their portfolios that include bonds, stocks, currencies, and other assets. Learning how to trade bonds will help a skillful investor to save and increase their capital.