So, what are bonds? Bonds are loans made for big institutions. When there’s a need for those entities to finance themselves, and due to the enormous value of those loans, debt is issued in the form of bonds so they can fund themselves through various sources. By investing in a bond, we’re buying part of a debt issued by the entity, hence we become a bondholder. Generally speaking, bonds are a relatively safe investment with more appealing profitability than a savings account.
Bonds can be issued by:
- Governments – They’re frequently considered virtually risk, this since, at least in theory, a government can always tax their taxpayers a little more to meet their obligations.
- Companies – Considered slightly riskier, but on the other hand, they offer a better interest rate.
Lastly, there are also high-interest-rate bonds, most commonly known by junk bonds. Mainly because they’re associated with companies or countries where there’s a higher probability of default.
To assess a bond, we must have into account some basic characteristics.
- Nominal value, which is the bond’s value when it’s initially issued. By owning a bond investors have the right to receive an interest rate, usually known by coupon rate.
- Coupon is the interest that’s paid by the debt issuer. It’s paid annually until it reaches its maturity date.
- Maturity date is the date when the bond reaches its end. When bonds reach their maturity rates the initial invested capital is returned to the investor.
To better illustrate how bonds work, let’s imagine we invest 1000$ in bonds, where when it’s issued the interest rate, or coupon rate is 5%, the loan term is 10 years, more commonly known by maturity date. Annually, for 10 years, we’ll be receiving an interest of 5%(50$). When the bond reaches its maturity we’ll be receiving the invested value and the accumulated interest during the 10-year period, which would total 1500$. The 1000$ initially invest plus the 500$ from the accumulated interest.
Most bonds, depending on the conditions, guarantee the initial invested capital, which makes bonds a relatively safe investment. There’s also the choice between fixed and variable interest rates. Although the variable rate might become a disadvantage if the interest rate drops and alters the forecasted yield.
There’s the chance of selling the bond at a higher price and profit from the difference. Also in case of bankruptcy, the bondholders are paid before the stockholders.
As we mentioned before, if the variable interest rate is chosen, the coupon rate might lower, hence, obtaining a lower interest rate throughout the rest of the bond’s duration. Compared to other assets, they offer a relatively low yield.
Even though bondholders are paid first, they are buying debt, which means, companies of countries, in case of bankruptcy, might not have enough liquidity to pay their debts.
These financial assets are probably better suited for investors that are looking to diversify their portfolio with low-risk assets.
Also a great option for individuals who have long term investment objectives, like for example, someone who’s setting up some sort of fund for retirement.
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