Bonds – also known as ‘Fixed income’ instruments – are used by governments or companies to raise money by borrowing from investors. In return, the bond issuer promises to pay back the investment, with interest, over a certain period of time. Bonds can play a vital role in any investment portfolio as they smooth out volatility and reduce overall risk by diversifying your portfolio.
There are Majorly Three Types of Bonds:
- Treasury Securities: Bonds, bills, and notes issued by the U.S. government and are the highest-quality securities available. Their maturity dates range from 30 days to 30 years. Their interest earned is exempted from state and local taxes. Treasuries are backed by the U.S. government; hence the timely payment of principal and interest is ensured.
- Municipal Bonds (“munis”): Issued by state and local governments to fund the construction of schools, highways, housing, sewer systems, and other important public projects.
- Corporate Bonds: Issued by corporations to fund a large capital investment or a business expansion. They tend to carry a higher level of risk than government bonds, but they generally are associated with higher potential yields.
How a ‘Bond’ Market Price is Affected by Prevailing Interest Rates?
Bond prices have an inverse relationship with interest rates — prices fall as interest rates increase as investors have more opportunities to generate higher yields elsewhere. Similarly, bond prices increase as interest rates fall as the bond’s coupon rate becomes more attractive compared to interest rates elsewhere.
Bonds or Equity?
Investing in bonds is simpler than doing so in equities, because there is a defined maturity. That is, the issuer of the debt instrument commits to pay back the invested amount on a specified date. They won’t surprise you as everything is clearly specified: interest amount, how often and when you will receive and when the principal amount will be repaid (i.e. maturity date). They provide attractive interest rates which are normally greater than those paid by banks on the savings account, especially for short term bonds (maturity is 1-4 years).
Why Invest in Bonds?
- Investment returns are fixed. Generally, we have a fixed maturity date. All bonds repay the principal amount after the maturity date; however, some bonds do pay the interest (coupon rate) along with the principal to the bondholders.
- Less risky compared to stocks. Besides receiving specified investment returns, bondholders are paid first over shareholders in the event of a liquidation.
- Bonds have clear ratings. Unlike stocks, bonds are universally rated by credit rating agencies like Standard & Poor’s, Moody’s and Fitch Ratings Inc. They are rated from AAA (highest grade) to C based on their creditworthiness.
- AAA bonds are perceived to have little risk of default and its issuers have a very strong capacity to meet its financial obligations.
- Junks bonds (BB and lower) have higher default risks and offer much higher yields as investors expect a higher return for the increased risk.
Risks Associated with Investing in Bonds:
- Bonds are also subject to various other risks: Having an inverse relationship with interest rates, your bond portfolio could suffer market price losses in a rising rate environment.
| Specific Entities | Default Risk | IR Risk | Currency Risk | |
|---|---|---|---|---|
| Treasury Bonds | Central Govt. | No | Yes | No |
| Muni Bonds | State Govt, City Council | Yes | Yes | No |
| Corporate Bonds | Banks, companies, trusts | Yes | Yes | No |
| Foreign Bonds | Govts, banks, cos, trusts | Yes | Yes | Yes |
| Tax Free Bonds | Govts, banks, cos | Yes/No | Yes | No |
Different corp bonds have different levels of default risk, depending on the issuer’s characteristics and terms of the specific bond. Coupon rate ∝ default risk at the time issuance.
- The interest rates on bonds are fixed hence their value may decrease during inflation.
- Returns on bonds are low when compared to stocks since the risk involved is low.
- Liquidity problems as bonds are not accessible until maturity. Even if it is sold, it may have to be sold at a lower price. Withdrawing the money before maturity is subject to penalties.
- Callable Bonds, i.e. even though the company has agreed to make payments plus interest toward the debt for a certain period of time, the company can choose to pay off the bond early, creates reinvestment risk. The investor is forced to find a new place for inventing the money and might not be able to find as good a deal.
The Bottom Line
Bonds have a place in every long-term investment strategy. Don’t let your life’s savings vanish in stock market volatility. If you depend on your investments for income or will in the near future, you should be invested in bonds. When investing in bonds, make relative value comparisons based on yield, but make sure you understand how a bond’s maturity and features affect its yield. Investment in treasury Bonds is indeed the safest and dependable. If you are thinking to invest in other bonds like corporate or municipal bonds, credit rating can be a deciding factor for your investment. Go for the bonds with high yield to maturity and coupon rate value along with minimum risk attached. Lastly, invest in the right bond at the right time!
