In layman's terms, bonds are loans. Essentially the investor lends a company, government or an organisation money. In exchange that entity agrees to pay the investor a specific interest rate, over a certain period of time.
What Are Bonds?
In layman’s terms, bonds are loans. Essentially the investor is lending the company, government or organization money. In exchange that entity agrees to pay the investor money back at a specific interest rate, over a certain period of time. As a result bonds are considered a safe investment, because there is the obligation to pay the loan back with interest.
How Bonds Work
Think of obtaining a consumer home loan. The lender (bank) will lend money based on the borrower’s qualifications. Do they have a good job, do they have good credit, and are there additional funds that can be used for payments? These are all questions a bank asks in order to decide how much they are willing to lend and how much interest they will charge. The better the consumer profile looks, the lower the interest rates. The higher the credit score, the lower the interest rate.
Bonds work exactly the same way. Bonds are given a rating from AAA and down. AAA, AA, A, BBB and so forth. The higher the bond rating the lower the interest the business will have to pay, in order to attract investors to buy the bond. The stronger the company or organization is the higher rating they will receive. The bond rating measures the risk that the bond will go into default, or the borrower (company) will be unable to pay back the bond, plus interest.
Types of Bonds
These are the highest rated bonds and come with the lowest interest rate. This is because they are backed by the full faith and credit of whatever government is issuing the bond. Governments have the ability to increase taxes on its citizens, in order to make the bond payments. As a result the risks are very low that a bond will go in default.
These are bonds that are issued by companies or corporations. They will vary in grade and interest rate because different companies have different strengths. In general, corporate bonds will pay higher than government bonds. They will also have a higher default rate, but typically still relatively low numbers.
High Yield Bonds:
These bonds are issued by companies as well, but will have a much higher risk of default and as a result will carry a higher rate of interest. Sometimes they are referred to as junk bonds.
Why Investors Like Bonds
Investors put money in bonds because they are seen as a safe way to invest money, while getting returns that are higher than bank deposits, CD’s and other secure investments.
Bonds offer monthly, semi-annual or annual interest to investors, depending on the type of bonds they invest in. For investors looking for retirement income, this is a very attractive feature of bonds. Retirees can have predictable income over the life of the bond. Since bonds are long term investments, this can provide investors with steady income for 10 to 20 years, depending on when the bond matures.
Preservation of Capital
During the life of the bond, only interest is paid. As long as the investor does not need to withdraw the principle amount, bonds can offer a great investment option that will maintain the principal, while providing the investor with regular payments. The full amount (face value or coupon) of the bond is paid at maturity.
While there are many intricacies to the bond markets, investors are attracted to bonds because of their safety and the regular income payments.
As with all investments it is important to diversify your portfolio, in order to limit your risks. This may include adding bonds to your holdings. It also may mean purchasing different grades of bonds at various maturity dates, to reduce risks.
There are no investments that are risk free. Understanding how bonds work, will help you make better decisions, allowing your hard earned money to work for you.
Paul Kinsella is a Partner & Senior Adviser at KnowledgebankIQ
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