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Once viewed chiefly as a means of earning stable income while preserving capital, bonds have evolved into a whopping $100 trillion global marketplace that offers virtually limitless investment options. Before you venture in to this huge and diverse market, it is important that you have a basic understanding of what bonds are and how the bond market operates.
What is a Bond?
Characteristics of Bond
- Par Value – The par value or face value is the amount that the holder of the bond will receive at the time of its maturity. Let us assume that Company ABC issues $100,000 in bonds to raise funds. It may do so by issuing 100 bonds to the public, each with a face value of $1,000. When the bond matures, the borrower, in this case Company ABC, will pay back the lender the par value of $1,000 per bond. In the open market, if a bond trades at a price below the par value, it is said to be selling at a discount. When a bond sells above its face value, it is said to be selling at a premium.
- Coupon Rate – The coupon rate is the interest rate, expressed as an annual percentage of the bond’s par value, which the issuer promises to pay the bondholder. For example, if there is a 5% coupon on a bond with face value of $1000, the holder will receive $50 each year until maturity. Typical coupon payment intervals are annual or semi-annual. If two bonds with same face values and maturities pay out different coupons, the price of the bond with a lower coupon rate will be lower in open market.
–The yield is the rate of return that an investor receives for investing in a bond. It can refer either to:
The current yield, which is simply the annual interest payment divided by the bond’s current market price, or
The yield to maturity, which is the total return anticipated from a bond if it is held to maturity.
Different types of Bonds and the different Issuers
Bonds come in many different configurations. Detailed below are the three most common varieties:
Federal Government Bonds – Also known as “sovereign debt,” they are the highest-quality securities available. These types of bonds are issued by national governments, with maturity dates ranging from 30 days to 30 years. Default risks vary depending on the state of the economy of the issuing country. U.S.Treasuries, U.K. Gilts, German Bunds, Government of Canada Bonds (GoCs) and Japanese Government Bonds (JGBs) are all examples of sovereign bonds. They carry some of the lowest yields around, but the default risk is also extremely low. However, in times of economic downturns, they relatively outperform other higher-yielding bonds. The interest earned by the bondholder is also generally exempt from federal income taxes.
- Local Government Bonds
– Bonds are also issued by state and local governments to fund the construction of highways, housing, or other important public projects. They tend to offer competitive interest rates but carry higher risk than sovereign bonds because local governments can go bankrupt. The interest earned is also typically exempt from federal income taxes and, in some cases, from state taxes also if an investor lives within the jurisdiction of the issuing state. The market for local government bonds in the U.S. is well established, where these bonds are called municipal bonds.
Corporate Bonds – Companies often issue bonds to fund a business expansion, or a large capital investment. Bonds issued by financially stable companies, who are more than likely to meet their payment obligations, are referred to as investment grade, while those issued by companies with low credit quality are called high yield or junk bonds. The yields in case of corporate bonds are higher than government securities because there is a greater risk of a company defaulting than a federal or a state government. Companies can issue bonds with either fixed interest rates or variable interest rates. Maturities can also differ. Corporate bonds are considered short-term when the maturity dates are less than 5 years; intermediate when maturities range from 5 to 12 years, and long-term instruments when the maturity dates are over 12 years.
How are Bonds priced?
Importance of Bonds in a model portfolio
- Capital Preservation – Bond issuers are legally bound to repay principal on maturity. This makes them appealing to investors who want to avoid the risk of losing capital.
- Capital Appreciation – If the prevailing interest rate drops, or there is an improvement in the credit standing of the bond issuer, the price of the bond in the secondary market is more than likely to rise, generating capital appreciation for an existing investor.
- Diversification – Since bonds often remain negatively correlated with stocks, they can cushion an investor against the unpredictable ups and downs in the equity market, reducing the volatility in a portfolio’s return.
Final few thoughts
Before you begin your bond journey, know your objectives. If you want maximum current income, high yield bonds are the answer for you. If preservation of principal is paramount, stick with investment grade bonds. Whatever be your investment target, you can’t afford to ignore bonds. If you are looking for the overall best online brokers have a look at the review section.