A Guide To Investment Bonds And How They Work
If you need money, a financial institution can lend you money and when government agencies or businesses need to borrow a lot of money, they issue bonds. They have access to thousands of investors, which allows them to raise significant sums. Companies use this money to finance new projects and governments to fund infrastructure and social programs.
What Is A Bond?
Your financial advisor may have already suggested investing in bonds. But do you know exactly how they work? These fixed income investments are issued by companies, the state or local governments that aim to borrow money from the financial markets. In return, they pay regular income to investors.
If you hold bonds, you have lent money and you receive interest in exchange for this loan. The interest rate and timing of payments are determined in advance as well as the term of the loan.
Bonds are among the most traded products on the stock market. You can buy bonds as easily as stocks; all you must do is place a purchase order via a broker. On the other hand, the calculation of the price of a bond is relatively complex than a stock.
The price of the latter depends solely on supply and demand. For a bond, a variety of factors come into play.
The company or organization that sells bonds is called the issuer while face value refers to bond price. The use of terms like principal and capital is common. The interest rate set by the issuer of the bond is called the nominal yield or coupon rate.
Debt And Equity Securities
A bond is a debt security while shares are equity securities. It is important to make the correct distinction between these two categories. When you buy an equity security (a share), you become the owner of a small part of the business. You have a right to vote and you will receive a portion of all future profits.
When you buy a debt security (an obligation), you become a creditor of the business or government. In the event of bankruptcy, you will be paid before the shareholder. On the other hand, if the business is flourishing and generates profits, you are not entitled to dividends or any payments before the maturity date.
In short, bondholders are exposed to less risk than shareholders but receive a lower return.
Equities typically outperform bonds. Historical returns calculated over periods of 10 years or more generally reflect this fact. However, bonds are well suited for investors who cannot tolerate the short-term volatility of the stock market.
If you are retired, most of your best investments should be fixed income since you cannot afford to lose any capital. You need this income to pay your bills. Conversely, if you are a younger investor planning to return to school in three years and you hold most of the shares in your retirement savings account, your strategy needs to be reviewed.
To avoid taking any risk with your education funds, it would be prudent to buy fixed income securities.
Most financial advisors recommend maintaining a diversified portfolio and changing its distribution over time. Thus, between the ages of 20 and 40, you should hold mainly shares. Then, from 40 to 60 years, you will gradually re-balance your portfolio in favour of bonds. When you retire, your savings will be mainly fixed income.
When you buy a bond, you usually receive interest periodically, which is calculated based on the face value of the smart investment. The interest is defined contractually when the bonds are issued. Unlike the dividend for a shareholder, the amount is paid regardless of the financial outcome of the business or government.
The issuer can repay creditors in using a specific method of interest.
- Fixed rate bonds – the interest rate is decided upon the issue of the bond.
- Variable rate – interest is based on a fixed and a floating rate (indexed on short-term bonds).
- Index-linked bond – the interest rate is recalculated during the holding period of the bond. For this reason, the nominal (amount of capital) at which this interest rate applies changes according to an indicator determined by the contract on issue. This is generally the rate of inflation in a given geographical area. This allows creditors to retain their purchasing power.
- Zero-coupon bond — available at a heavily discounted price and income is capitalized and paid in full at maturity. Short-term investment bonds often use this system.
When a bond reaches its due date, the issuer must repay creditors in various ways. These include;
- The issuer can pay the entire amount on the due date
- The issuer can repay a portion of the investment annually and interest is calculated on the basis of the remaining capital
- The issuer may reimburse creditors not in cash but in shares
How To Buy Bonds?
You can buy a bond, including the best fixed rate bonds from an authorized financial intermediary, such as a broker, bank’s financial advisor or directly from an issuer. Bonds online provide a more convenient way to invest money in a hedge fund or different types of bonds issued by governments, businesses or municipalities.
If the issue price is equal to the nominal value is regarded as at par value. Premium variants come with an issue price that is different from the nominal value. You can also buy bonds directly on the stock market (secondary market).
It should be noted that these purchases bear transaction costs, which is generally not the case when investing money directly with the issuer.
The fixed income investments are deposited in an ordinary securities account (typically not eligible for a stock savings plan). For this service, the intermediary may charge custody fees. The returns presented in the issue documentation are exclusive of fees and taxes. Do not forget that the investment is subject to income tax.
The nominal value of the loan corresponds to the applicable amount divided by the number of bonds issued. It can be £1, but there are also issues with a nominal value of £100 or even £100,000. However, it is important to note that any resale of a bond before its maturity can result in a gain or a loss.
How To Sell Your Bonds
Bonds listed on the stock market can be sold before the maturity date with the help of your financial intermediary. In the event of a sale before the maturity of the bond, the bondholder may be subject to risk. The market value of the bonds may fluctuate and drift from the redemption value at maturity.
As a reminder, the price of the bond equals its nominal value multiplied by the percentage of the quote. Interest due for the holding period of the bond is included in the calculation. The accrued interest is calculated on a pro rata basis between the issue date of the bond or the date of the last interest payment and the settlement date of the bond.
What Are The Risks For A Bondholder?
Ratings agencies like Fitch and Moody’s regularly assess the financial status of companies and governments. They classify issuers according to their level of risk and may declare junk status. For instance, S&P and Fitch downgraded South Africa’s status to junk status in 2017 following years of economic decline.