Know bonds well

January 14th 2013

While talking about investing, the first thing that comes to your mind is of course investing in the stock market. Investing in the stock market is exhilarating and offers a bouquet of opportunities to amass wealth. Moreover, successful investing stories always center round triumphant investment in the stock market. On the contrary, bonds always play second fiddle to stocks in regard to wealth creation. During the raging bull phase, bonds look unimpressive whereas the stocks hog the limelight. However, during the bear phase, when the share prices plummet, the investors can realize the importance of bonds. The safety and the stability offered by bonds provide much needed solace to the investors. Any wise investment portfolio should be a smart mixture of stocks and bonds.

Bond is a debt security in which an investor loans money to an authorized issuer. The authorized issers such as the corporate or the government entity borrow funds for a stipulated period of time at a pre-determined rate of interest. Generally, bonds are issued by the government, states, municipalities and companies to arrange funds for a variety of projects and activities. The issuer of the bonds is obligated to pay coupon (rate of interest) and it is also obliged to pay the principal amount to the bondholder upon maturity. Interest on bonds is generally paid semi-annually. The most common types of bonds include US Treasury bonds, notes and bills, corporate bonds and municipal bonds.

Whatsoever, if you purchase a bond, it implies that you become a creditor to the corporation or the government whoever issues the bond. The main advantage of being a bondholder is that you have higher claim on assets than the shareholders do. In case the issuer goes into bankruptcy, a bondholder is treated more favorably than a shareholder. In case the issuer makes profit, the bondholders are not given the share of it, but the shareholders are entitled to get the dividend. It is axiomatically true that stocks fetch more returns than the bonds, but it is not to say that you should not invest in bonds. Rather, portfolio with proper combination of stocks and bonds, provides you the chance to wealth creation as well as much needed stability and security. Whatsoever, before investing in bonds you should be well aware of different bond-related aspects. The list of different things, that you must know about bonds, are listed below.

Relatively safe investment option

Unlike the stocks, bonds are relatively safe investment option. The interest amount and the principal amount, payable to you, are fixed in case of bonds. However, this does not imply that bonds are absolutely risk free. Bond investors have to worry about inflation risk as well as liquidity risk.

Basically all bonds are same

Bonds are available in the market place in different name such as credit securities, debt instruments, fixed-income securities, etc. By whatever name you call the bonds, all of them are basically same. All the bond documents contain few things such as pay-back date, interest rate and the terms.

Bond price varies inversely with rate of interest

You need to keep in mind that the price of a bond varies inversely with rate of interest. Suppose the rate of interest or the coupon is 5% and a bond issuer issues a bond of $10,000. Here the interest payment to the bondholder is $(10,000*5)/100=$500. Now, say the rate of interest has increased to 6%. Now, in order to maintain the same yield $(8,333*6)/100=$500, the bond price has to be reduced to $8333. If you hold a bond until it matures, the changes in the rate of interest do not matter to you. However, in case you sell the bond that you hold before its maturity, the price it fetches depend on the prevailing rate of interest in the market place.

Bonds are of different varieties

You need to keep in mind that bonds are available in different varieties. Bonds can be issued by the government, public corporations, private corporations, states, municipalities, cities, government-sponsored agencies and other public authorities. Bonds can be of very short term period or of 30-year duration.

Bond ratings are available

Bonds can be of investment grade type, junk type or in between these two types. Leading rating agencies such as the Standard & Poor’s, Moody’s and Fitch Ratings, give ratings to bonds in terms of safety. These ratings are indeed very useful while investing in bonds.

Whatsoever, your investment portfolio should comprise of stocks as well as bonds. You should remember the above mentioned basic things while investing in bonds.

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