Basics of Investing: Bonds
Have you ever forgotten
to bring enough money and had to borrow from someone? You must have. All of
us have had to borrow money sometime in our lives. And there are usually all
kinds of reasons as to why we need to borrow money.
and even governments, might need to borrow money from time to time. However,
the sums of money that they borrow are very large. So what they do is that they
What are Bonds?
Bonds are basically
loans, where you are the lender. The companies
or government which borrow the money from you, have to agree not only to pay
back the amount they borrowed, but also to pay a little extra in the form of
a fee (interest) for the privilege of borrowing your money. These interest payments
(coupons) are usually paid at regular intervals (for example, every year). The
full amount that is loaned out (the principal) is returned back to the lender
(you) at a certain date. This date is called the maturity date.
Bonds are I.O.Us.
It is a piece of paper in writing that says that such-and-such company borrowed
so much money from you. The main difference between stocks and bonds is that
the company guarantees to pay you back your principal, plus interest.
You know exactly how much you are going to get back, and when you are going to get
Bonds with less than
1 year to maturity are known as money market instruments (there are unit trusts
which invests solely in these money market instruments).
Bonds and money
market instruments are also known as 'fixed-income' investments. This is because they pay out a regular
'income' (the interest coupons) to investors.
How risky are Bonds?
Although the company
whom you lent your money to guarantees to pay you back, it does not mean
that Bonds are risk-free.
Companies, and even
governments can, and do go bankrupt. However, when that happens, bondholders
will be at the front of the creditors' line, while stockholders would be at
the rear of it.
But perhaps the most
risky thing to bondholders is rising inflation rate. When the economy is booming and unemployment rates are falling, that is
when bonds and bondholders suffer the most (the reverse applies. Recessions
are great for bonds!). Inflation causes prices of things in general to rise.
This means that $10 in the future would be able to buy less goods and services
than $10 now. So your fixed fee from bonds would buy you less if there
Which also means that
the money which you get back when your bond matures, would be worth a lot less
than what it is worth now when you loan it out. So the faster inflation rises,
the faster your bond loses value.
Interest rates is
another thing bond investors watch out for. Rising interest rates cause bond
prices to fall, and vice versa. This is because bonds pay a fixed coupon. As
interest rates fall, people are willing to pay more money for the bond because
it's fixed coupon may represent a higher return than interest income. Conversely
when interest rates rise, people are less willing to hold on to bonds because
interest income would be higher than the fixed coupon, hence leading to a fall
in bond prices (or what's called capital depreciation).
Bond Unit Trusts
If you see bonds as
an essential part of your investment portfolio, but yet lack the time or investment
capital to buy into local bonds (which can be very high in value), then opt
to invest in a Bond Unit Trust. Bond unit trusts are basically a collection
of different types of bonds. Instead of an individual bond, you are buying into
a ready portfolio of bonds.
A lot of people opt
for bond unit trusts when they seek to diversify their investments with some
fixed-income exposure. Even 'growth' investors invest in bonds when the
timing calls for it (see Investing
In Unit Trusts - Strategies for how this is done).
Next : - Money Markets