Unlike stocks, bonds don’t give you ownership rights. They represent a loan from the buyer (you) to the issuer of the bond.
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debt holders, or creditors, of the issuer.
Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year.
Unlike stocks, bonds issued by companies give you no ownership rights. So you don’t necessarily benefit from the company’s growth, but you won’t see as much impact when the company isn’t doing as well, either—as long as it still has the resources to stay current on its loans.
Bonds, then, give you 2 potential benefits when you hold them as part of your portfolio: They give you a stream of income, and they offset some of the volatility you might see from owning stocks.
Types of Bonds
Government bond- A government bond or sovereign bond is an instrument of indebtedness issued by a national government to support government spending
Corporate bond- Corporate bonds are issued by corporations and offer a higher yield relative to a government bond due to the higher risk of insolvency. A bond with a high credit rating will pay a lower interest rate because the credit quality indicates the lower default risk of the business.
For example, if a company wants to build a new plant, it may issue bonds and pay a stated rate of interest to investors until the bond matures. The company also repays the original principal.
- Agency bond- a security issued by a government-sponsored enterprise or by a federal government department other than the U.S. Treasury.
Municipal bond- are issued when a government body wants to raise funds for projects such as infra-related, roads, airports, railway stations, schools, and so on. Municipal bonds can vary in term: Short-term bonds repay their principal in one to three years, while long-term bonds can take over ten years to mature.
Advantage of Bond Investment
Fixed Returns on Investment- Fixed investment in Bonds yields regular interests at timely intervals. Also, once a bond matures, you receive the principal amount invested earlier. The best advantage of investing in Bonds is that the investors know exactly how many the returns will be.
Less Risky- Although Bonds and stocks are both securities, the clear differences between the two are that the former matures in a specific period, while the latter typically remain outstanding indefinitely. Also, the bondholders are paid first over stockholders in case of liquidity.
Less volatile- Investing in bonds is safer than the stock market, which also has several other risks. Although a bond’s value can fluctuate according to current interest rates or inflation rates, these are generally more stable compared when compared to stocks.
Disadvantage of Bond Investment
Less liquid compared to stocks- Most major corporations may have high liquidity, but bonds issued by a smaller or less financially stable company may be less liquid as fewer investors are willing to buy them. Bonds with a very high face value will also be less liquid, but the companies with low face value won’t find any investors easily.
Bankruptcy- Bondholders may lose much or all their investment in case a company goes bankrupt. In the economy such as the USA, bondholders are given much leverage and protection laws in case of bankruptcy. This means investors are expected to receive some or all of the invested money. But in many countries, there are no protections for investors.
Characteristics of a Bond
A bond is generally a form of debt which the investors pay to the issuers for a defined time frame. In a layman’s language, bond holders offer credit to the company issuing the bond.
Bonds generally have a fixed maturity date.
All bonds repay the principal amount after the maturity date; however some bonds do pay the interest along with the principal to the bond holders.
How to Invest in Bonds
New bonds: You can buy bonds during their initial bond offering via many online brokerage accounts.
Secondary market: Your brokerage account may offer the option to purchase bonds on the secondary market.
Mutual funds: You can buy shares of bond funds. These mutual funds typically purchase a variety of bonds under the umbrella of a particular strategy. These include long-term bond funds or high-yield corporate bonds, among many other strategies. Bond funds charge you management fees that compensate the fund’s portfolio managers.
Bond ETFs: You can buy and sell shares of ETFs like stocks. Bond ETFs typically have lower fees than bond mutual funds.
Yield: The rate of return on the bond. While coupon is fixed, yield is variable and depends on a bond’s price in the secondary market and other factors. Yield can be expressed as current yield, yield to maturity and yield to call (more on those below).
Maturity: The date that the bond expires, when the principal must be paid to the bondholder.
Coupon Rate: The interest payments that the issuer makes to the bondholder. They are typically made semi-annually (every six months) but can vary.
Duration risk: This is a measure of how a bond’s price might change as market interest rates fluctuate. Experts suggest that a bond will decrease 1% in price for every 1% increase in interest rates. The longer a bond’s duration, the higher exposure its price has to changes in interest rates.
Bonds are an effective option for those who need a steady and dependable source of income. Investing in bonds is what elderly investors do after retirement majorly. Selecting bonds carefully, purchasing them at the right time, and knowing the Advantages and Disadvantages of Bonds can be a big help for prospective investors.