What is a Bond? How do Bonds Work? As a new investor you will definitely want to know about this. You may be a small investor. You may want to start investing with little capital. That could be $500 or $1,000. And investors with little capital want safe investments. So many people invest in bonds to earn safely.
Big investors also invest in bonds to diversify their investment portfolios. This reduces their investment risk.
So now I am going to discuss about “What is a Bond? How do Bonds Work?”
What is a Bond?
A bond is a debt instrument that is issued by governments and corporations to raise funds. Bond is also called fixed income security. That means investors will get fixed periodic interest payments. Since it is a fixed income security, it pays relatively less interest. After the maturity period of the bond, the bond issuer is obliged to pay the value of the bond to the bondholder.
Bond prices can rise and fall over time. Investors are more interested in buying bonds when the value of the bond is higher and eagerness is decreased when the value of the bond is lower.
If the maturity period of the bond is higher, this bond tends to offer higher interest and bond with shorter maturity tends to offer lower interest. High quality bonds also offer lower interest rates.
Who are the issuers of Bonds?
Companies, municipalities, states, and sovereign governments can issue bonds.
Companies borrow from lenders through bonds to increase their funds. These funds they invest on business expansion. For example, purchase of land or construction of new installations. They can also invest in any profitable sector.
The government issues bonds to raise funds to finance on development projects. Such as construction of roads, bridges, schools or other facilities. Since the government never goes bankrupt, it is much safer to buy government bonds.
How do Bonds work?
The proceedings of the bond are governed by a set of rules. Most government or corporate bonds are publicly traded and some bonds are traded over-the-counter (OTC) or privately placement between the borrower and lender. .
The money raised by the government by issuing bonds is invested in various development projects of the government such as construction of roads, bridges or dams. Government bonds are considered the safest. However, the amount of interest on government bonds is lower than that on corporate bonds.
The funds raised by corporate organizations that issue bonds are used to expand the business, including ongoing investment projects. When issuing a bond, they promise to return the face value of the bond to the lender at the end of the term of the bond. Bond holders receive interest as a return. The amount of interest depends on various factors such as the credit quality of the issuing institution, the length of the maturity period, etc.
If the bond issuing authority sees that the interest rate on the bond is declining in the market, they can repurchase the bond and re-issue the bond at a lower interest rate.
If you want to invest in bond you must know how to buy a bond.
What is an example of a bond?
Suppose ABC company issues a 10-year bond with a face value of $20,000 and a coupon rate of 5%. If the investor buys the bond subject to this condition, he will receive $1,000 per year as interest over a 10-year period. And after 10 years, the company will return $20,000 to the investor.
Terms of Bonds that you should know
The amount that the bond issuing company or government pays to the bondholder at the maturity of the bond is called face value. Basically bonds are issued at this price. This is also called “par value”. Suppose you buy a bond for $1000, then this $1000 will be considered as the face value of the bond.
The coupon rate
The rate of interest that the bond issuer pays to the investors. The Interest rate is calculated on the face value of the issued bond. Suppose a bond is issued at 4% coupon rate then bondholder will get 4% x $1000 face value ($40) each year.
The maturity date
The maturity is the date on which bond issuer pays the face value of bond to the bond holder. We can say it is the ending period of the bond.
Different types of bonds
Bonds issued by the government are called treasury bonds. This bond is considered the most secure bond since it is issued by the federal government. But the flip side of this bond is that its interest rate is relatively low. Treasury bonds are issued in various forms such as bills, notes, bonds. When a treasury bond is issued for a period of 1 year or less, it is called bills, when issued for 1-10 years it is called notes and maturity with more than 10 years is called bonds.
When a company issues bonds to raise the amount of funds, it is called corporate bonds. The purpose of raising money through corporate bonds is to alleviate the financial crisis in the ongoing investment of the company, to refinance the loan, to diversify the investment or to set up a new plant. If the financial condition of the company is very good then it is safe to buy the bond of that company. But if the financial condition of the company is not good, it is not safe to buy the bond of that company.
When a bond is issued by states, municipalities or counties is termed as Municipal bonds.
Funds that are raised from issuing munis bonds are usually spent on the development of state or city projects. This bond may offer tax benefits. This means that the bondholder can get an exemption from the tax levied on the interest on the bond.
Bonds that do not pay any coupon payments during their lifetime are called Zero-coupon bonds. So you may be wondering what is the benefit to the investor by buying these bonds? Yes, there is a discount benefit in Zero-coupon bonds. Zero-coupon bonds are issued at a much lower price than face value. When this bond is matured then investors will receive this amount.
Convertible bonds are the bonds that can be converted into the shares of the issuing company’s stock at some point.
When a bond is converted into a stock, the bondholder benefits as much as the company benefits. The benefit of the company is that they can pay less interest than the interest of the bond. And the benefit of the investor is that if the company succeeds in the project then they will get more profit from the upside in the stock.
Callable bonds give the option to the company to buyback the bond before its maturity at some points.
Callable bonds are good for issuing companies. This is because when companies see their credit rating rising or the bond interest rate falling in the market, they repurchase the bond from the bondholder and reissue it at a lower interest rate.
Callable bonds are not a good investment for investors. This is because when the price of a bond continues to rise in the market, it will be called by the bond issuing company. As a result the investors cannot take advantage of the rise in the price of the bond.
Puttable bonds are the opposite of Callable bonds. Callable bonds give the option to the company to buyback the bond before its maturity at some points. But puttable bonds give the option to the investors to sellback the bond prior to its maturity at some points.
Puttable bonds are good options for investors. This is because when investors see that the value of the bond is constantly declining in the market, they can resell it to the company.
What is the difference between bond and stock?
The main difference between stocks and bonds is that you can be a legal owner of a company through buying stock but you can’t be the part of ownership of a company through bonds. The shareholders receive dividends from the company and the bondholders receive interest from the company.
Shareholders can participate in the management of the company. They have voting rights. But bondholders can’t participate in the management of the company and have no voting rights.
Shareholders get a dividend when the company makes a profit and do not get anything if company makes a loss. But the interest rate of the bondholders is fixed. Whether the company makes a profit or not, the bondholders are paid the interest on time.
Are bonds a good investment?
Bonds can be good investment option for those who don’t want to take too much risk. Bonds are called fixed income securities. They want to take that opportunity. At regular intervals they receive a certain amount of interest.
But if you can take the risk, it will be better for you to invest in stocks. However, before investing in the stock market, one must have a good knowledge of the stock market and must have a good idea about the investment strategy.
But the ideal investment is to invest in a portfolio which is mixed up with stocks, bonds and other financial instruments. There is a rule of thumb that when you are 20 you should not have more than 10% of your portfolio investment in bonds, but when you are 65 you should have 40% or 50% of your portfolio investment in bonds.
Why do people buy bonds?
The main reason behind buying bonds is that the income of the bond can be predicted in advance.
Investors feel safe knowing in advance how much they will earn ( interest) from investing in bonds each year. Investors get full principal at maturity if they hold it.
Even if you have little idea about how to start investing you can safely invest in bonds. Because here the flow of income is fixed. On the other hand, if you invest in stocks, the flow of income can be more or less. Just as investing in the bull market has the potential for higher returns, so investing in the bear market can lead to lower returns.
Basically people invest in bonds as safe investments and offset exposure to more volatile stock holdings.
What are the advantages and risks of bonds?
Advantages of Bonds
Capital Reserve Investing in bonds will keep your capital safe. At the end of the bond period you will get your entire capital back.
Fixed income flow If you invest in bonds, your income flow will be fixed. You will receive interest at certain times of the year which will continue till the bond maturity.
Secure Investments Investing in bonds are considered relatively safe investments. Bonds act as a balancing force on the investment portfolio.
Risks of Bonds
If the financial condition of the bond issuer is fragile, issuer may fail to pay interest or principal at the right time.
There is a call risk in Bond. The bond issuer may call the bond when the bond interest rate continues to decline in the market. In this case, the investor may be deprived.
If the investor holds the bond till maturity, he will get full face value and interest. But if investor wants to sell the bond before maturity, most of the time he has to sell at a discount to attract buyer.