In our previous article, we had previously spoke about the different types of investments investors can usually take. Today, we will go in depth into the fundamentals of bonds and what are some of their characteristics. If you are still in doubt on the type of investments you want to take right now, read on to see if bonds are your type.
What Are Bonds?
As previously mentioned, bonds are loans made to governments or corporations, where the borrowing party agrees to pay the bond back at a promised date. Until then, the borrower makes agreed-upon interest payments to the lender, also known as the bondholder. It is similar to borrowing money from your friends or family and promising to pay them interest until a promised date where you then pay them back in full. That is why bonds are also known as fixed-income securities, securities that are founded on debt. The lender receives income in the form of interest payments and if the lender holds the bond to maturity, he/she can get all his principal back. This is what makes a bond so safe.
If you are wondering, why bonds? It is because bonds are more appropriate for when you are unable to tolerate short-term volatility. Of course, when you have figured out the type of investor you already are, you would know what your level of risk tolerance is. (Read more: Which Investor Personality Type Are You?)
Now, if you think that bonds are apt for your portfolio diversification, then let’s move on to understand how bonds work. Note that they do have a number of characteristics that determines the value of a bond and to what extent it fits into your portfolio.
i) Face Value
The face value (also known as the par value or the principal) represents the amount of money the holder (or lender) will get back once a bond matures. This face value is however, not the price of the bond as the price of the bond fluctuates according to changes in interest rates, while the face value remains the same. A bond with face value (e.g. $1,000) can be considered as trading at a premium price (e.g. $1,100) which is above its face value, or at a discounted price (e.g. $900) which is below its face value. Of course, the price is also determined by the credit rating of the bond, the entity issuing the bond and the time left till maturity date.
ii) Interests (aka coupons)
As mentioned above, bond holders tend to receive interests also known as coupons. This coupon could be arranged to be paid monthly, quarterly or annually. Singapore Savings Bonds for example, pays interest every semi-annually.
iii) Maturity date
The maturity date is represented a date in the future on which the lender/bondholder would then receive his principal amount. There is no one fixed maturity duration as it can range from as short as one day to 30 years. Of course, the longer the maturity, the higher the interest as it carries more risks as compared to one that matures in one year. The yield-to-maturity graph is usually represented by a Yield Curve.
iv) Entity issuing the bond
This is one very important factor to consider when purchasing bonds as the issuer’s stability is definitely any investor’s main concern on getting their principal back. If you are purchasing a Treasury bond (T-bond) from the US government for example, your investment is virtually risk-free as you don’t have to worry about the US government defaulting on its debt. Should your bond offers you a highly attractive interest rate, you should be dubious about the corporation offering it. Companies can also default on bonds, offering highly attractive interests knowing that they may not be able to pay up. The highest paying and highest risks ones are often called junk bonds. As such, you should always refer to bond ratings from the three big credit agencies such as Fitch, Moody’s, Standard and Poor’s ratings to determine a company’s credit risk.
Example of Moody’s Ratings:
|Bond Ratings||Investment Quality||Credit Risk|
|Ca||Highly Speculative||Some prospect of recovery|
|C||Lowest||Little prospect of recovery|
Source: Moody’s Investors Service, 2016. “Rating Symbols and Definitions.”
That being said, there are also different types of bonds out there. Depending on your risk tolerance level, you can choose from municipal bonds, government bonds, corporate bonds, mortgage-backed or asset-backed securities and international bonds. Within each sector, you will find different types of bonds with different issuers, credit ratings, coupons, and maturities etc. As such, there arise different types of risks in holding these bonds and it is important that investors are aware of it before diving in. Interest rate risk, Reinvestment risk, Inflation risk, Credit Risk, Rating Downgrade risk and Liquidity risks are major bond risks any bond investor would face. Each bond offers its own risk and reward which you, as an investor have to find a balance in. The key reason to buy bonds is to diversify your portfolio and note that bonds may not be suitable for everyone as each have their own investing preferences.
Remember to do your research and think twice like how you would before lending money!
Moody’s Investor Service, 2016. “Rating Symbols and Definitions.”