Investment in Bonds – Key things you should Know Before Investing

Are you one investor who is investing in stocks, bonds, shares, mutual funds, etc? But before investing are you aware of these terms? 

Well! If not. Don’t worry. Here in this blog, we are going to share some key things you should be well acquainted with about bonds before investing. 

So let’s dive into the article below to find out about bonds. 

What are bonds?

A bond is basically a debt security that is the same as an IOU. A bond is an agreement between borrowers and investors in which borrowers issue some bonds to raise money from investors and are willing to lend them money for a certain amount of time with high interest. 

When you are buying a bond that means you are lending your money to the issuer. The issuer of these bonds might be a government, municipality, or corporation. 

In return, the issuer or borrower promises to pay you a specific amount of rate of interest throughout the life of the bond along with the repayment of the principal, which is also known as the face value or par value of the bond your bond gets mature after a set period of time.

Types of bonds

There are different forms of bonds available in the market. Each bond comes along with its own set of benefits and risks. 

Below are some lists. 

Corporate bonds

Generally, corporate bonds tend to offer a higher interest rate than any other type of bond. but the corporate sectors that issue them are more likely to default than government entities.

Municipal bonds

Otherwise referred to as muni bonds, these are basically issued by states, cities, and any other local government entities to finance any public projects or to offer public services.

For example, the government might issue different municipal bonds to build a new bridge or to construct a neighborhood park.

Treasury bonds

Shortly called T-bonds, these are issued by the U.S. government. These bonds lack default risk. So they don’t have to offer higher interest rates like corporate bonds.

Why do people buy bonds?

Investors buy bonds because of the following reasons. 

• Bonds provide a predictable income stream to investors. Typically, they pay higher interest twice a year.

• If the investors held their bonds to maturity, they may get back the entire principal that they hold, so bonds are an effective way to preserve capital while investing.

• Bonds help investors to offset exposure to more volatile stock holdings.

But what do Companies get? 

Different Companies, corporate sectors, governments, and municipalities issue bonds to pool money from the public for various things, which may include

• To provide operating cash flow
• To finance debt 
• To fund different capital investments in schools, highways, hospitals, and other projects

Benefits of investing in bonds

Bonds offer a host of advantages to investors. They include

Capital preservation

Capital preservation refers to the protection of the absolute value of your investment amount or principal via different assets that promise the return of principal. 

As bonds typically carry relatively less risk than any stocks, these assets can be proven as a good choice for investors who have less time to recoup losses.

Income generation

Bonds generate a fixed amount of income for investors at regular intervals of time in the form of coupon payments.

Diversification

Investing your money in a balance of stocks, bonds, and other asset classes, help you to build a portfolio that may seek returns but is resilient through all market environments. 

However, stocks and bonds typically share an inverse relationship status which means even if the stock market is down, bonds become more appealing.

Risk management

Fixed income can be broadly understood to carry relatively lower risk than stocks. This happens because fixed-income assets are generally less sensitive to different macroeconomic risks, like economic downturns and geopolitical events.

Invest in a community

Municipal bonds help you to give back your part to a community. These bonds may not provide a much higher yield than a corporate bond, but they are often used to help build a hospital or school that can improve the standard of living or lifestyle for many people.

Risks associated with an investment in bonds

In any investment, there are certain risks associated with the benefits. Buying bonds also entails certain risks that are given below:

Interest rate risk

There is heavy interest rate risk in any bond which means when the interest rates of any bond rise, bond prices fall. So the bonds that you hold currently may lose value. So Interest rate movements are one of the major risks of price volatility in bond markets.

Inflation risk

Inflation is the period in which the price of certain goods and services rises over time. So if the rate of inflation outpaces the fixed amount of income a bond provides, the investor may lose their purchasing power.

Credit risk

Credit risk also referred to as business risk or financial risk is the possibility that the issuer could default on its debt obligation.

Liquidity risk

Liquidity risk is the possibility or a period when an investor might wish to sell a bond but is unable to find a buyer to purchase.

Stocks vs bonds

Although suspected of higher risks, stocks tend to earn more money than bonds. If you notice the previous dates, that is the period from 1928-2010, stocks averaged a return of 11.3%; while bonds returned on average of 5.28%.

Apart from that, bonds may freeze your investment for a fixed period of time. For example, if you bought a 10-year-bond, but are unable to redeem it for 10 years. This may create the potential for your initial investment to lose value. However, stocks can be sold at any time.

How to make money from bonds

There are two ways to generate money by investing in bonds.

The first way is to hold your bonds until their maturity date and collect their interest payments on them. The interest amount of the bond is usually paid twice a year.

The second way to generate profit from bonds is to sell your bonds at a price that’s higher than you initially paid.

For example, if you buy a bond at a price of 10,000 at face value that means you paid 10,000 and after a certain period when the market value increases to 11000, you sell them for 11,000 so that you can pocket the 1,000 difference.

Bond prices generally rise for two main reasons. If the credit risk profile of the borrower improves that means they’re more likely to be able to repay the bond at their maturity, then the price of the bond may typically rise. Apart from that, if the prevailing interest rates on any newly issued bonds go down, then the value of an existing bond goes up at a higher rate.

The bond prices and the interest rate of a bond tend to have an inverse relationship which means 

they move in opposite directions. If the prevailing interest rates of any bond increase, prices for existing bonds are likely to fall as the coupon it offers becomes less valuable when compared to new bonds.

When the Federal Reserve aggressively hiked the interest rates up to 2022, the interest rates may have gone up, but bond prices have generally gone down.

However, not all bonds pay interest. Some bonds also offer a return once they’ve matured known as zero-coupon bonds. As these bonds don’t pay interest, they are especially sold for a deep discount to their face value.

The Bottom Line

Although the bond market seems complex to you, it is really driven by the lower risk and return tradeoffs of the stock market.

Once an investor masters the few basic terminologies and measurements to unmask the familiar market dynamics, they can become a competent bond investor. 

Once you got a hang of the lingo, the rest is very easy.

*image source from Google

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