What are Bonds?
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A bond is a fixed income investment whereby an investor (you) lends money to the borrower (typically a company, government or local body). The investment is usually for a fixed period of time at a fixed interest rate.
Key Features of Bonds – the jargon
Coupon payment – this is the interest paid on the bond expressed as a percentage. You can calculate this by multiplying the coupon rate by the face value of the bond.
Coupon rate – this is the rate of interest paid on the bond’s face value.
Coupon dates – dates on which the issuer will make the interest payments.
Face value (or par value) – the bond price when it is first issued and the amount the issuer will pay you at the maturity of the bond.
Maturity date – the date on which the face value is due for payment.
Bondholder – the investor (you) who has the right to receive the face value on maturity.
Term – the length of time between the issue date and maturity date of the bond.
Yield-to-Maturity (YTM) – a way of calculating the value of a bond.
How Bonds Work
The issuer will issue a bond that includes the term of the bond, coupon rate, coupon dates and maturity date.
There is usually a minimum amount to invest – often $10,000, with increments of $1,000 above that.
At each coupon date you will receive the interest payment and at maturity you will receive the face value.
During the term of the bond you are able to sell the bond. The market value of the bond can change over the term of the bond and can differ from it’s face value.
The market value of a bond is inversely correlated with interest rates – when rates go up, bond prices fall and when rates go down bond prices rise.
Factors that can affect the current price of a bond are the credit rating of the issuer, the coupon rate of the bond relative to current market rates, the time left to maturity, how many coupon payments are left and the supply and demand of bonds in the market.
You can buy bonds through financial advisors, broking firms or directly through the issuer – via a public offer. The most common method is through a broker.
Advantages of Bonds
You receive a predictable and steady income stream – coupon payment.
You can get a profit on the bond if you sell it at a higher price (interest rates fall).
If you hold your bond to maturity you will get your principal (face value) back.
Bondholders have priority over shareholders in a company but rank behind secured creditors.
Disadvantages of Bonds
Issuers can default on your bond.
Bonds tend to pay out lower returns than equities – but have lower risk.
If you need to money before maturity then you may have to sell the bond at a loss (if interest rates have risen).
Final things to Consider
Bonds are a good way to spread the risk in your investment portfolio. They can offer more stable returns and generally lower risk than equity investments.
The market value of a bond can differ from it’s face value and therefore you can lose money on a bond if you sell it before the maturity date.
You must make sure that the coupon payments and bond maturity dates align with your cash flow requirements.
Make sure you review the credit rating of the issuer and the bond. This will help you assess the risk of the investment. A credit rating agency assigns these ratings to the issuer.
It you are investing in several bonds then consider having different issuers, across different industries with different maturity and coupon payment dates.
Good luck with your investing….
James