BOND – Complete 101 Guide
A Bond is a terminology which means a fixed income instrument which is made by an investor to the borrower. In simple words, it is just a document between the lender and borrower to guarantee a transaction.
i.e. you as an individual lends some of your money to a company, government or a big firm and in return, the company issues his bonds which states that you agree on getting a specific interest on that payment along with the complete amount itself after a certain period of time in future which is fixed by the company.
Basic Characteristics of Bond (Terminology)
1. The Face value of the bond (also referred to as par value) is the amount a person will receive from issuer or lender of the bond upon maturity of the bond. It should not be confused with the price of bond in the market at any current moment, the face value is a given and fixed amount while the market value fluctuates over time.
2. The Coupon rate ( or the yield) is the interest rate which the bond issuer will pay to the bondholder whether annually or semi-annually. It is usually calculated based on the face value. It is expressed in terms of percentage only and it can either be fixed or variable (explained further)
3. The Date of maturity refers to the date at which the bond will mature and on the same day the bond issuer is supposed to pay the face value to the bondholder.
4. The Issue Price refers to the price while the bond is originally sold.
5. Default Risk: It is referred to a chance that any entity whether a company or a person will be unable to make the required payments on their Debt obligations. Refer this article for in-depth info on default risk
5. The bonds you buy may not trade at their face value. If they are trading below their face value then they are trading at the discount. If they trade at more than face value then they are said to be trading at a premium.
6. Market Rates of Interest: This needs to be explained with an example – Suppose you bought a bond last year with a coupon rate of 5% when market rates of interest were also 5% and you decided to pay $1000 for a single bond. Now the market interest rate has risen to 6%.
Now if you will decide to sell this bond no one will pay $1000 for a bond which is yielding 5% when the market rate of interest is 6% because the new buyer can buy new bonds which is offering 6% coupon rate.
So if you want to sell your bond you will need to sell it at a lower rate than you bought it for i.e. at a discounted price(less than $1000).
and on the other side if the market interest rate becomes lower from coupon rate then you will be able to sell it at a higher price and people will be willing to buy it at a higher price(higher than $1000) i.e. at a premium price.
Let’s see an example:
Suppose there is a company named XYZ Company and you decided to buy its 10 bonds at $1000 face value each, then you will have to pay the company $10,000 to buy the 10 bonds
So, the face value is the amount at which the bond was issued originally.
This amount will be repaid to you in complete after the end of the bond maturity that can be X (e.g. 5, 10 years) amount of years.
Now you must be thinking if I pay $10,000 and I get $10,000 back after X years then what is the profit of me in buying these bonds.
That is when the coupon rate comes in, it is the interest you receive periodically. Now, the interest rate can be anything decided between both the parties let’s say it is Y%.
Then the final process would be that you bought 10 bonds worth $10,000 of $1000 value each at a coupon rate of Y% and you waited for X years. Then you will receive Y% of $10,000 each year till maturity i.e. X years.
How do Bonds Work
Understanding Bonds is not as simple as it seems, don’t be like that guy who thinks just buying when the price is low and selling when the price is high will make you a millionaire.
Understanding the basic concepts of bonds is necessary for making any significant income with bonds.
Those who prefer to buy bonds, they consider it to be simply a loaning amount which the issuer will receive after a fixed time period. By the end of that time period, the value of the bond should be paid. Each bond has a face value and these values can fluctuate based on the market condition. The return investors getting on their bond is generally called as the yield. The bond’s yield is inversely related to the market price.
For example, if your bond has a face value of $100 and it fell to a market price of $90 then the yield of the bond would go up to 5.55 %. If the price of a bond goes up to $110 then the yield is calculated at 4.54%.
When the market value of bond fluctuates , the face value is redeemed at the end of the final time period when the bond ends. If the yield of a bond is high, the risk lives are also high. There are more chances that the private company or the government will not able to repay the money.
The risky bonds usually offer a high return and it is definitely an attractive option for all the investors. In fact, the government bonds are sold out in the auction and based on the demand the investor feels confident about it.
How to Buy a Bond
Now, you are well aware of what bonds actually are, how they work but now the point arises how to buy these bonds.
Exactly what we have explained in the content below.
Here are a few ways to buy a bond, make sure to select the sellers wisely before investing in a bond.
1. The most preferred choice to buy a Government bond is to buy it through the US treasury department. It is a must for you to be 18+ years legally, the Social security number, and a bank account in USA bank.
2. You can also reach the brokerage to buy the bond, there are many online brokerages who sell treasury bonds, municipal bonds, and corporate bonds.
3. The final choice to buy a bond is to buy through the mutual funds or via the exchange-traded fund. If you don’t have much cash you can buy using the bond fund. You can get a lot for a smaller cost, they usually don’t have any maturity and the interest payment also is not stabled. Moreover, there is no guarantee for income as well.
Things to consider when buying Bonds
When an average investor goes into the market and tries to invest in a bond it is difficult to analyze the opportunities and falls. Hence we have given the steps which can be used on a primary level to evaluates the opportunities and avoid falls as a beginner.
- Will, the entity (government or company) will be able to pay back the bonds, this is the first question you should be asking your self before lending the money in exchange of bonds.
Well, this can be easily done with the help of rating agencies which rate the bonds on a grade basis AAA being the highest grade level and then decreasing.
Moody’s, Standard & Poor’s and Fitch are the industry leader in this.
- Cooperate Bonds: Evaluating cooperate bonds is a bit different. Nerdwallet has an awesome explanation regarding it you can check it out.
- Government Bonds are considered as the risk-free assessments because the chances of failure of govt are thin like hair.
And another reason for such a remote chance of failure is govt can recover the money through taxation.
- Municipal Bonds: Although municipal bonds have a clean history, they are not rock solid safe as they can fail to pay the bonds. Additionally, you can check this link for getting the audited financial statements and financial disclosures with any defaults of municipal bonds.
Check out other factors which can affect your bonds selecting ability here.
Types of Bonds
There are numerous types of bonds out there and we have listed all the available type out there which you can come across.
Each bond has different advantages and disadvantages attached to it and every bond is useful in one sense or other.
The bonds are of different type and it is usually a contract between the issuer and the investor under the legal provision. Here is a different type of bond which an investor can consider.
Sovereign Government Bonds
The Sovereign Government Bonds are issued by the sovereign government and it comes under U.S. Treasury. The U.S government includes various bonds apart from the primary obligations, it is must to fulfill some mandate and these bonds are considered to provide higher yields.
The musical bonds are issued by the local as well as state government. The best part about Municipal Bonds is, it is totally tax-free and you can enjoy a lower interest rate. Moreover, when you are opting for the municipal bonds the investor can invest in the civil projects.
This type of bonds is issued by private companies, corporate companies, and the companies in partnership. These are usually the commercial enterprises and offers higher yield as compared to the rest of bond type.
The taxation part is not favorable when it comes to corporate bond. The investor can pay up to 40% of their total interest income in the form of taxes. Hence, the corporate bond is not an attractive choice when it comes to the best bonds.
These Bonds are also referred to as redeemable bonds because they can be called off by the lender(business) at any time when they feel the market rates of interest is moving in the favorable direction of the company. They offer high-interest-rate to attract customers and compensate for the sudden calling of bonds.
These types of bonds allow the bondholder to force the bond issuer to repurchase the bond before the date of maturity.
This can be due to certain reasons such as if market rates increase then the bond value will decrease so to avoid loses the holder can call of the security before maturity.
Risk of Investing In Bonds
Although everything worthwhile comes with a risk factor attached to it so does the bonds.
We have listed the most common risk factors which the bondholder must access before trading (buying or selling) bonds.
The bond is a great and smart investment choice but here are the major risks involved if you are planning to invest in the bonds
This type of risk refers to the probability of not getting the expected promised interest rate. The credit risk is generally managed by dividing the bond into 2 groups one is junk bond another is investment bond. The highest investment bond is considered as the Triple AAA-rated bond. The higher the rating of the bond, the chances of default is less.
The bond is less liquid and once acquired and be super difficult to get sold for a higher amount. It is always advisable to buy individual bonds which you can hold up to the maturity time.
When it comes to government policies, it can take a potential or unintentional turn and it can lead to inflation. If the bond is variable then there is some sort of built-in protection. The higher inflation value can lead to loss of purchasing power and you may find the buying prices to be high when compared to the principal return amount.
When you are buying a bond, you expect it to give you some amount of interest on a regular basis or at least during the maturity. It is better not to distribute the interest amount in the form of deposit or cheques, it can reduce the final value. Moreover, you cannot predict the final rates which you can use again for the reinvestment purpose.
Investing in bond should be done with the utmost care, make sure to consider the credit ratings and duration of the bond. Always look for good deals and interest value. Bonds are truly the safest way to invest your money. Look for a reliable service provider who can help you out with growing bond value.
Bonds is not an easy topic at all but it can be learned and with right practice, you can easily go for the best bonds and make easy money.