What Is A Bond?
Like modern day peer to peer lending, bonds are where you lend money to a company (corporate bonds) or a government (government securities, government bonds or treasury bonds). This money is lent for a set period of time and you receive interest payments at regular intervals known as coupons in return. With individual bonds you will also receive the face value of the bond back at the end of the pre-determined loan period otherwise known as the maturity date. This could be one, three, five, ten or more years in the future, depending on the bond.
Fixed or Floating Interest Rates:
The interest you receive back can either be a fixed or floating rate (like fixed or variable home loan repayments). A fixed rate means you receive the same amount of interest throughout the life of the bond, but with a floating rate of interest which means you may receive more or less depending on the cash rate set by the Reserve Bank, the bond market sentiment (the market price for bonds) and the financial position of the issuing company or government.
It’s also important to consider the interest rate (coupon) offered because if this is lower than the rate of inflation then the value of your money will not be growing in terms of your spending power.
Low to High Risk Bonds:
A company that is perceived to be at a higher risk of default (not able to maintain interest payments) will typically pay a higher rate of interest. Therefore, higher yielding bonds often carry more risk. This is also why government bonds typically pay a lower rate of interest because they are unlikely to default on their bond repayments.
If a company or government that issues a bond runs out of money and defaults on the bond, then you may not get back all or some of your investment back. In the event that this happens bondholders are repaid prior to shareholders. This is why you should check the investment rating of a bond. All bonds are given an investment rating by Moody’s or Standard & Poor (S&P) (a market intelligence company established some 150 years ago) so that investors understand the quality of the debt they’re buying.
Capital Loss v Capital Gain:
It is also important to remember that if you wanted to sell the bond before its maturity date, you may not get back the full amount that you invested. This is because bonds typically trade at a discount or a premium and rarely at their true or face value. This is because bonds have an inverse relationship with interest rates.
When interest rates go down bond prices go up (this can be a good time to sell and make a profit or capital gain). When interest rates go up bond prices go down. (this can be a good time to buy for a discount). It’s important to remember that as interest rates continue to drop, bond prices continue to climb, conversely as interest rates continue to climb, bond prices continue to drop. This means that you will need to make enough money from the coupons (interest) the bonds are paying to make up for the capital loss to break even or to exceed the capital you invested to make a profit if you buy when interest rates are going up.
Publicly Listed Bonds:
Both corporate and government bonds can be traded on a stock exchange (exchange traded bonds) or OTC (Over The Counter) through a broker.
The two main types of government bonds that are typically listed on the stock exchange:
Treasury Bonds: These are medium to long-term debt securities that carry an annual rate of interest fixed over the life of the security. Interest is paid every six months, at a fixed rate, which is a percentage of the original face value. The bonds are repayable at face value on maturity.
Treasury Indexed Bonds: These are medium to long-term bonds. The capital value of the bonds is adjusted for movements in the Consumer Price Index (CPI), which measures inflation. Interest is paid quarterly, at a fixed rate, on the adjusted face value. At maturity, investors receive the capital value of the bond - the value adjusted for movement in the CPI over the life of the bond.
Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.
Disclaimer: At Evarvest we believe in making investing and investment education more accessible, but we don’t provide investment advice and individual investors should make their own decisions. While we try our best, we cannot ensure the accuracy of the information we provide.
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