Bond Basics 101
If you’re looking for one of the most common investments, you should consider looking into bonds. This form of investment has a long history and is puzzling to finance experts, but we break down the basics of bonds that can improve your portfolio.
A bond is a loan given to a government or company by an investor, by issuing a bond a government or company borrows money from investors who in return are paid interest on the money they’ve loaned. Governments and companies frequently issue bonds to fund ongoing expenses or new projects.
Investors get into bonds as a way of preserving the money they have while generating additional income and bonds are considered a less risky investment compared to stocks. Bonds can also be used to diversify a portfolio among other investments.
For example, the government is planning on constructing a new park and they issue bonds with the goal of raising money for the project for the face value of $1,000 with the promise of paying it back with a maturity of over 10 years. They make this loan more attractive to investors, the government agrees to pay an annual interest known as a coupon rate of 5%, and with an investment of $1,000 the government pays the investor $50 for each year until the bond reaches maturity.
Once the bond has reached its maturity, the investor redeems their bond, and the government returns the principal investment of $1,000 which benefits the city as well as the investor. Bonds are considered a more predictable and stable form of investment offers regularly scheduled payments and a return on invested principal.
If you compare the regular payments of stocks and bonds, stock profits and losses are driven by market forces that are generally less predictable. Though bonds are less risky compared to stocks, one risk factor investors face is the possibility the entity issuing the bonds defaults on paying back the principal which is known as default risk.
Typically bonds with higher default risks also have higher coupon rates with the amount of risk depending mostly on the financial stability of the person issuing the bonds. For example, governments are considered stable bond issuers with a relatively low coupon rates.
Corporate bond issuers are considered at a greater risk of default as companies can go bankrupt which is why corporate bonds offer a higher coupon rate. There are several credit ranking agencies that assign ranks to different bonds that can help investors gauge the financial strength of the bond issuer.
These agencies often use different criteria for measuring risk and it’s recommended to compare ratings when considering a typical bond. Another thing to consider is the credibility of some ranking agencies that aren’t always accurate which is another factor to consider when comparing agencies.
Another risk with bonds is the interest rate risk which is the pattern of interest rates increasing and any bonds you own will be worth less if sold before the maturity date. When interest rates rise, more investors allocate their money to the new, higher-interest-rate bonds.
If investors are looking to unload a low-interest-rate bond to take advantage of these new rates, investors will have to sell their bond at a discount to make it a worthwhile purchase for another investor. Many investors utilize a mixture of stocks and bonds to pursue their investment goals. As bonds are moved differently from stocks, they can help increase or protect portfolio returns.
Though bonds pose less of a risk, they are similar to other investments compiled of complex pieces with a variety of uses and risks. Before considering investing in bonds, it’s important to invest in your own financial education because no two investment portfolios are alike. The research for this article was sourced from Trader Forex on Blogspot.