A bond is a debt instrument that a government or a company issues to raise money. It is a contract between a government or a company acting as the borrower and investors acting as the lender.
When you buy a bond, you lend money to the government or company that issued the bond, and in return, the government or company that issued the bond agrees to pay your money back, with interest, at some point in the future.
Think of it this way. When you buy a house, a bank creates a contract—a mortgage in this case—wherein the bank lends you money, and you agree to pay the bank back, with interest, at some point in the future. With a bond, you are like the bank, the government or company is like the home buyer, and the bond is like the mortgage contract.
Features of a Bond
When most people envision a bond, they picture a certificate that states how much the bond is worth, the interest rate that will be paid out on the bond, and the date on which the bond will mature. Some of the salient features of bonds are:-
- Face value is the amount the bond will be worth at maturity and the amount the bond issuer uses when calculating interest payments.
- The coupon rate is the interest rate the bond issuer will pay on the face value of the bond.
- Coupon dates are the dates on which the bond issuer will make interest payments.
- The maturity date is the date on which the bond will mature, and the bond issuer will pay the bond holder the face value of the bond.
- The issue price is the price at which the bond issuer initially sells the bonds.
Bonds Categorization Based on Issuing Entity
The government issues these bonds. These are generally considered low-risk investments. However, this is not true for all markets, and investors need to be aware that some government bonds, for example, those issued in emerging markets, may carry higher levels of risk. On the flip side, such bonds can provide investors access to investments offering additional income and growth profiles. As a result, government and corporate bonds remain the largest sectors of the market.
These bonds are issued by companies, both public and private sectors. Corporate bonds are usually of two types:
Investment grade bonds are the ones that have high credit ratings like A, A+, AA, or AAA. Large companies and governments issue these bonds. These bonds are suitable for retail investors as they carry less or no default risk and guaranteed returns.
Speculative grade bonds are issued by companies perceived to have lower credit quality and higher default risk than more highly rated or investment grade companies. Ratings can be downgraded if the credit quality of the issuer deteriorates. Conversely, they can be upgraded if fundamentals improve.
Bonds Categorization Based on Features
Bonds could be categorized based on features like coupon, maturity, etc.
Fixed Rate Bonds
In Fixed Rate Bonds, the interest remains fixed throughout the bond’s tenure. A constant interest rate makes fixed rate bonds resistant to changes and fluctuations in the market.
Floating Rate Bonds
Floating rate bonds have a fluctuating interest rate (coupons) per the current market reference rate.
Zero Interest Rate Bonds
Zero Interest Rate Bonds do not pay any regular interest to the investors. In such types of bonds, issuers only pay the principal amount to the holders.
Inflation Linked Bonds
Bonds linked to inflation are called inflation-linked bonds. The interest rate of Inflation linked bonds is generally lower than fixed-rate bonds.
Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds enjoy interest throughout.
Bonds that are given less priority than other company bonds in case of a closedown are called subordinated bonds. In liquidation cases, subordinated bonds are issued of more importance than senior bonds, which are paid first.
Bearer Bonds do not carry the name of the bondholder, and anyone who possesses the bond certificate can claim the amount. If the bond certificate gets stolen or misplaced by the bondholder, anyone else with the paper can claim the bond amount.
Any government issues War Bonds to raise funds in cases of war.
Bonds maturing over time in installments are called serial bonds.
Any government issues Climate Bonds to raise funds when the country is concerned with adverse climatic changes.
How do Bonds Provide Returns?
The allure of any bond is its yield, the total return, which is the sum of the interest payments added to the principal. There are two ways of making money on bonds:-
- The first is to collect the interest payments until the bond matures.
- The second way is to sell the bond for more than you paid for it before the point of maturity. By selling the bond through a broker, it’s possible to make a capital gain depending on what has happened to the issuer’s credit quality.
Buying and Selling of Bonds
You can buy and sell bonds on the open market just like you buy and sell stocks. However, the bond market is much larger than the stock market.
Here are a few terms you should be familiar with, though when buying and selling bonds:
- The market price is the price at which the bond trades on the secondary market.
- Selling at a premium is the term used to describe a bond with a market price higher than its face value.
- Selling at a discount is the term used to describe a bond with a market price lower than its face value.
Conclusion: Bonds for Investment Diversification
Investors can reduce their risks by diversifying their assets. Bonds are one type of asset, along with shares, cash, and other investments.
Investors also can diversify the types of bonds they hold. For example, investors could buy bonds of different maturities—balancing short-term, intermediate, and long-term bonds—or diversify their bond holdings by combining corporate, treasury, or municipal bonds.
Investors with a greater risk tolerance may decide to buy bonds of lower credit quality, accepting higher risks in pursuit of higher yields. More conservative investors, however, may prefer to limit their bond holdings solely to high-quality bonds, avoiding riskier or more speculative bonds.
Instead of holding bonds directly, investors can invest in mutual funds or exchange-traded funds (ETFs) focusing on bonds. Investors should base their decisions on their circumstances.