What is a Bond?
Do you save your money or invest it?
Like many people, you may have grown up knowing that you should have savings. It is indeed a good practice to have savings. But is it the best way to safeguard your financial future?
To some extent, it is good enough.
But in many other ways, investing your money is a better alternative.
Investing is a term used to refer to various ways of making an income from your money. One way of making this income is by investing in a bond.
By reading this article, you will learn the basics of bonds so as to be able to invest in them. You will also know the different types of bonds as well as their advantages and disadvantages.
Before we get to the basics, let’s differentiate between bonds and their close relative, equity.
Bond vs Equity
Bonds and equities are two ways in which you can earn money from investing in a company. Both are investment opportunities but are very different from one another.
The biggest difference is in what happens after the initial purchase.
When you become an equity holder, you essentially become a shareholder. A certain percentage of the company becomes your property.
When the business does well, you get a share of the profits in the form of dividends. With a bond, the situation is different.
When you buy a bond, you become a creditor to the business.
The business owes you money equivalent to the amount you have put in as well as other payments like interests.
You however do not become a shareholder neither do you share in the profitability of the company.
Although shares attract a lot of attention as they get reported in the mainstream media, bonds are equally popular.
This is especially the case with long-term investors or those putting their money away for reasons like retirement.
This is because bonds have some advantages which shares cannot rival. More on this in the section about advantages and disadvantages of bonds.
To understand bonds, let’s look at the common terms used when talking about them.
You can use this list as a reference when you need to recall these basics.
There are certain terms whose meaning you must know if you are to understand bonds.
Below are those we will look at in this section.
A bond issuer is the person, organization or government institution which issues a bond. It is the body which is in need of funds and has decided to get them via this method.
It may have other financial options available such as bank loans, sale of shares but has chosen the bond option. The issuer is responsible for setting the terms of the bond.
These terms are what will determine the attractiveness of the bond.
As the party borrowing money, the issuer’s credit rating will also play a role in determining the attractiveness of the bond.
The lender is the person, organization or institution which lends money to the bond issuer by purchasing the bond issued.
The lender will typically analyze the terms of the bond before deciding whether to buy it or not.
Since buying a bond is an investment decision, the lender needs to be savvy in regards to this matter. If the lender is not experienced, he will normally hire an expert to do the analysis for him.
The expert will then advice on which bonds are best to invest in.
The amount which totals the investment made by the lender is what is referred to as the principal. This is also called the bond’s face value or par value.
The principal is the the amount of money the issuer will pay the bondholder once the bond matures.
For example, the bondholder may have invested $10,000 in a bond whose maturity date is 5 years. At the end of this period, the issuer will pay back $10,000 to the lender.
The principal never changes and it must be paid back in full. This is separate from all other payments which are paid in the course of the investment period.
Every bond issued has a date by which the lender is supposed to be paid back his money. This date is called the maturity date.
Depending on the bond, the maturity date could be anything from 5 – 10 years. Some bonds have a longer maturity period.
Whatever the period is, the lender has to know it before purchasing the bond.
A bond’s coupon is its interest.
When a bond is issued, part of the agreement is for the issuer to pay the lender small amounts of money periodically.
This payment is normally done either annually or semi-annually.
For the coupon to be determined, the coupon rate has to be known too.
The coupon rate is simply the interest rate. It is the coupon rate that fixes the amounts payable every set duration.
The amounts are calculated as a percentage (coupon rate) of the invested amount (principal).
This is the date of a coupon payment.
Since coupons are paid either once or twice a year, the counting starts after the bond purchase.
Often, this will be the same day for the bondholders.
The bond’s yield is the return offered by the bond. It is a measure of how profitable the bond actually is. This measure is often used when deciding which bond to invest in.
Yield is measured in two ways: current yield and yield to maturity.
Current yield represents the return you will get for holding the bond for one year.
Yield to maturity on the other hand, calculates the total return you get from holding the bond till maturity.
TYPES OF BONDS
With these terms aside, let’s look at the types of bonds you can invest in.
Coupon bonds are the most common type and also most attractive.
They are simple to understand as they don’t have many options to consider other than the interest payment, rate and maturity date.
Coupon bonds are those which offer a coupon payment at the end of a specified period. This period is either annually or semi-annually.
The coupon will be calculated according to the principal and coupon rate and paid accordingly.
This is what provides a guarantee source of income which is synonymous with bonds.
These bonds do not have coupon payments as is the case with coupon bonds. They are also called accrual bonds.
The only payment offered is the total accumulated value at maturity.
This does not make them unattractive. They attract investors by initially trading at a discount.
For example, an issuer may need $1 million for a project. He may then opt for a bond whose par value is $1,000.
Since he does not intend to have coupons as part of the deal, he can then sell the bonds at $980.
This means that for every bond purchased, the investor will get a $20 discount.
If you buy the bond, you will actually have spent $980 and saved $20. You will thus have “earned” $20 through savings.
Callable bonds provide the option of the bond being “called back” before maturity. This means that the issuer can buy them back some time in the course of the bond period.
This can pose some challenges for you as the investor, while making it easier for the issuer to manage his financial burden. Bonds will typically be called when the market interest rates are falling.
This helps the issuer to sell bonds at a lower coupon rate, thus reducing his burden.
If you are an investor of such a bond, then you lose an opportunity of selling your bond at a high price. The high price will be occasioned by the lower interest rates.
For example, your bond could have provided a 5% coupon rate.
Most likely, this was the prevailing interest rate in the market. After 3 years, the prevailing market rate falls to 4%.
This makes your bond, which pays at a coupon rate of 5%, more valuable than those currently in the market.
With a higher value, the bond trades at a higher price. This offers you more profits if you sell.
On the other hand, the issuer will opt to buy back the bond so that he cuts down on the high coupon payments.
The new bond he issues will now have a coupon rate of 4%.
These bonds are very similar to callable bonds only that they work in reverse. With putable bonds, it is not the issuer who buys back the bonds. It is the bondholder who sells the bond back to the issuer.
This option can prove very useful for you in the future if you suspect that the bond would fall in value.
If it does, you will be able to get back your principal and invest it elsewhere. Preferably in the more valuable bonds coming into the market.
The situation for this comes when new bonds are being issued with higher coupon rates. This reduces the value of the bond you are currently holding.
Traditionally, you would have been locked out of this new investment by the maturity period which is not yet due.
With a put option, you get to sell the bond and use your money to buy another one.
Putable bonds may not be very common but they come in handy when the issuer seeks to pay lower coupon rates. The option to sell the bond when needed attracts many bondholders. As such, the issuer is guaranteed to raise the required amount easily.
These bonds offer an option of converting your bond investment into the company’s shares.
They provide this option for the investors who may be interested in it.
However, the option can also be of great benefit to the issuer.
Since the option is stated at the beginning, as an investor, you will know about it.
But of greater importance to know, is the reason behind the option being included.
Bonds are a means for organizations or governments to borrow money for a project. You will thus have to look at the project being undertaken to be sure of the possible benefits.
If the project will be successful, then you can convert your bond into shares and sell them later as the prices go up.
This is likely to happen because with the success of the project, there will be more people interested in the company’s shares. This makes the prices go up, offering you a profit if you sell.
For the issuer, converting your bond into shares will be a welcome move.
The biggest benefit is that the issuer will no longer need to pay coupons periodically.
That means reduced expenses.
At the same time, once you are a shareholder, it means there is no principal to be paid at maturity. That is another plus for the issuer.
This outcome will actually make the company more profitable since their expenses will be reduced.
The situation will be similar to when there are fewer creditors.
These are just like the convertible bonds but with a slight difference.
They are convertible for stocks though not of the issuing company.
These bonds will offer the opportunity for bondholders to convert their investment into the stock of a company in which the issuer has a stake.
The stake held by the issuer will then be “shared” with you. This makes you a shareholder in the other company.
With this in mind, you need to examine carefully the details of the bond agreement before buying it.
You may also need to consult some experts to know the profitability of the company whose shares are on offer.
ADVANTAGES OF INVESTING IN BONDS
Bonds are an investment option taken by many. But as usual, it isn’t the only available one.
When it comes to investment options, there are preferences.
Some people prefer certain options while others prefer different ones.
If you are just getting started in investments or are looking to diversify your portfolio, how do you know whether bonds are a worthy choice?
Here are some advantages to consider.
Better Than Banks’ Savings Account
The tradition way of saving money as known by many is through a savings account.
The thought of putting your unused money in a safe place is good enough.
But when the bank tells you that your money will earn you interest, it becomes better.
But just what is it better compared to?
Certainly not bonds.
When you invest in bonds, you will prove this for yourself.
If you have ever calculated the interest rate offered by your bank, you will realize it is really small. Bonds on the other hand, offer a better payment than your bank.
In fact, your bank is most likely investing in some bonds.
Most preferably government bonds or others from stable companies.
The combination of bonds investing and loans is what makes banks report huge profits.
If you are keeping your money in the bank, it will be a good idea to consider moving it to a bond.
Provide Guaranteed Income Streams
One great beauty of bonds is the annual or semi-annual payments of coupons.
Depending on your needs, this payment can easily take care of your expenses.
Especially if your investment in the bond is big.
These payments are guaranteed in the bond agreement and unless something drastic happens, the payment cannot fail.
One of the unfortunate turn of events which could stop the flow of this income is the bond being called.
As explained above, this basically brings to an end the bond agreement.
Something else that could happen is the issuer being declared bankrupt.
This automatically stops the payments. But the good thing is that your investment (principal) is largely protected by law.
Apart from these situations and any other like them, you are always assured of getting your interest payment at the date agreed upon.
Offer Legal Protection in Case of Bankruptcy
One of the biggest advantages of bonds over shares is the legal protection under the law.
Bondholders and shareholders both have a stake in the company.
The stake is however significantly different, particularly in the eyes of the law.
This difference becomes clear when the issuer is declared bankrupt.
A declaration of bankruptcy is an investor’s nightmare. If you are a shareholder, you will experience the worst part of the nightmare since your investment will be gone.
If you are a bondholder, you will also suffer some losses because you will no longer be able to receive periodic coupon payments.
Nevertheless, you will often be guaranteed to have your principal paid back.
This will happen either in full or partly. It will depend on the exact financial situation the issuer is in.
The law dictates that bondholders should be treated like creditors.
Therefore, when a company starts paying back its lenders, bondholders are one of those guaranteed to receive payment.
While creditors like banks may come first, rarely will bondholders lose out on all their money.
This is unlike what happens to shareholders who are not prioritized.
Potential for Reduced Tax Burdens
Some bonds, especially those from the state government or municipality can be tax-free. The interest paid from these will enjoy either reduced taxes or be entirely free of tax deductions.
When the government issues such a bond, it is often looking to attract investors.
As such, the tax incentive is meant to entice as many investors as possible.
This happens mostly when the issuer perceives that there is little interest in the market for bonds. It can also be used to supplement a low coupon rate.
The current market rate may be quite high and so to match up to it, a tax incentive can be utilized.
Investing in a bond which promises reduced or no tax deductions can be a good decision.
Apart from saving you the time and expense involved in filing, your income will be higher than if you invested in taxable bonds.
Preservation of the Principal
The preservation of your principal is yet another laudable advantage of the bond investment.
When the bond matures, you get your principal paid back to you in full. This gives you the opportunity to reinvest it somewhere else.
Of course, being a shareholder gives you something similar though not quite.
For shares, you will have some work to do. You will have to trade your shares at the current market price in order to get your “principal” back.
This can be tricky considering that there may be little to no interest in the shares of the company.
Also, the prices may be too low for you to recover your initial investment amount.
More than that, you may have to spend more time waiting for enough people to buy all your shares in case they are many.
The bond investment definitely stands out in making your life easier.
You will receive back your money with little effort from your end.
DISADVANTAGES OF INVESTING IN BONDS
Many advantages do not mean the absence of disadvantages.
With all the good that can come from investing in bonds, here are some risks involved.
The Risk of Being Called Back
One of the biggest risks involved in bonds comes from the possibility of being called back.
As discussed in the section on callable bonds, this is not your preferred situation.
First of all, you incur a loss in the sense that you will no longer receive the expected income.
Upon the bond being called, you will no longer receive the remaining coupon payments. Note that those payments were in your plan. You probably had set your recurrent expenses to benefit from them.
Now that they are no longer available, what do you do?
You will most likely opt to buy another bond. Whereas this is a good choice, the coupon rates are now lower.
That means less income coming your way.
This is the second challenge which you will face. And part of the challenge is getting a bond which offers a good deal.
Most bond purchases require some time to check them out and confirm their suitability.
The industry in which the issuer operates is also important to consider.
You may need an understanding of the factors which could affect the bond’s future performance.
This exercise may take precious time at a time when you are looking to quickly re-invest your money.
Interest Rate Risks
Risks associated with fluctuating interest rates can cause an unfortunate situation for your bond investment.
This is because you become stuck in a situation which you probably want to opt out of.
For example, you may have invested in a bond paying at a coupon rate of 6%.
With changes in the market interest rates, new bonds with a higher rate, say 6.5%, become available.
You will have to choose one of two choices. Stick with your bond till maturity or sell it and buy the available ones.
If you choose to stick with your current bond, you are choosing a lower income according to market rates.
If you choose to sell your bond and go for the new bonds, you suffer loss since your current bond has decreased in value.
It will not be attractive to investors.
This makes selling difficult.
The decrease in value means that selling will attract a lower price than what you bought it for.
Credit Rating Risks
In most cases, it is easy to avoid this risk because you first investigated the bond before buying. Credit rating risks are those associated with defaulters.
This is where the bond issuer may fail to pay the promised coupons.
In most cases, many investors still seek external advice. When an issuer’s credit rating falls, it means that he is likely to default on coupon payments.
This could point to worse scenarios in the future.
The project which necessitated borrowing may not raise enough money to pay coupons. The issuer could also be having no money to facilitate the payments.
In this case, even your principal is at risk.
Some bonds come with no collateral backing. T
his means that if the issuer is unable to pay, your money is lost. To cover for this, such bonds, usually called debentures, will often have higher coupon rates.
Bonds offer an attractive investment option that is way better than a bank’s savings account.
Find out what moves the industry involved and understanding the factors which could affect your bond’s value.
Once you settle that, make your investment and enjoy the benefits.