Bonds: Meaning, Type, Benefits and Risk
Introduction to Bonds
A bond is defined as an investment product where people, companies, or governments borrow money from investors. When you purchase a bond, you are providing a loan to the issuer-whether it's a country or a corporation-for the right to receive regular payments of interest while promising that your principal will be repaid on a specific date in the future. Bonds are a highly popular source of income with considerably lesser risk than stocks. It's time now to understand more about bonds. Meaning, types, benefits, and risks are found under the auspices of this chapter.
Bonds Simply put, a bond is essentially an IOU issued by a party. When you purchase a bond, that entity agrees to pay you a regular rate of interest periodically, usually annually or semi-annually. This amount is referred to as the coupon. At maturity, which is the end of the life of a bond, that issuer pays your investment back in face value, also known as principal.
Bonds are typically viewed as being riskier than stocks due to their guaranteed pay, and the issuers of the bonds are legally bound to pay the interest on the money borrowed. However, like all investments, bonds are not risk-free.
Types of Bonds
There are literally hundreds of types of bonds, each with different features and objectives. Here are some of the most common types of bonds.
1. Govt. Bonds:A government bonds issue to raise funds for public projects or debt management. Such bonds are extremely safe as the government has promised the repayment to the bondholders. In India, the central and state-level government issues a central and state-level government bonds. For example, Indian Government Savings Bonds are issued by the central government.
2. Corporate Bonds:These are floated to raise money by corporations for expansion purposes, operations, among others. The corporate bond would normally earn the investor a higher interest rate compared to the government one but has a higher risk since companies might default on their payments.
3. Municipal Bonds:These are bonds issued by state or local governments for financing public projects like schools, roads, or hospitals. They are generally free of federal taxation and sometimes from state or local taxes. They are safer than the government bond but not as safe as government bonds.
4. Zero-Coupon Bonds:These bonds make no regular interest, but are sold at a significant discount from their face value, and the investor gets the full-face value at maturity. They are called "zero-coupon" since they do not offer a coupon or a flow of interest during the life of the bond.
5. Convertible Bonds:These bonds may be exercised upon converting them into a specific number of the company's shares. This converts the bond into equity if the company's stock price rises, enabling the issuer to reap capital gains.
Advantages of Bonds
Bonds have numerous advantages over investors, hence become the favorite for most of the investors.
1. Regular Income: Many people invest in bonds primarily because of the regular income they create. Bonds pay a coupon rate at regular intervals. These coupon payments may be remitted to investors as a stable cash inflow.
2. Capital Preservation: Most people view bonds as riskier than equities, especially with government and high-grade corporate bonds. The principal is usually repaid to the investor at maturity, so there is relative safety in investing capital.
3. Diversification: Inclusion of bonds in an investment portfolio helps achieve risk balance. Bonds are generally not thought to move in a similar direction with the stocks and so help distribute risk and can improve stability in a portfolio.
4. Tax Advantages: A few bonds carry tax benefits, such as muni bonds. The interest credited from these bonds would be exempted from federal or state income taxes, depending on what applies and what the local, state, or federal government has ordained.
5. Less Volatile: Bond prices tend to be more stable compared to equities; this converts into the return volatility, thus suitable for conservative investors or approaching retirement.
Bond Risks
While bonds do have several advantages, at the same time, there are several risks inherent to bonds, and an investor must be aware of all these factors:
1. Credit Risk: It's the likelihood of the issuer of the bond-government or a firm-to default in paying interest or to return the capital at maturity. The more a firm possesses a bad credit rating, the greater the related credit risk of issued bonds. A bond default would be a loss for the bondholders.
2. Interest Rate Risk: The price of bonds varies inversely with interest rates. Increases in interest rates make the prices of outstanding bonds naturally downward sloping. It occurs because new bonds are issued at higher interest rates and thus, "older" bonds sold at lower rates become less attractive. If you have to sell your bond before maturity, you could lose money in the process if interest rates have been raised.
3. Inflation Risk: Inflation erodes the purchasing power of money with time. If inflation rises more rapidly than your interest rate on your bond, then your real return might decrease. For example, let's assume you are getting a fixed interest rate of 4% on your bond. Now if inflation stands at 6%, your real return is negative.
4. Liquidity Risk: It is a situation in which bond issued by smaller companies or from less developed markets might not be sold off in a quick manner. This is known as liquidity risk. You can face potential losses if you want to sell your bond before its maturity date because you may not receive a fair market price.
5. Reinvestment Risk: If the bond issuer pays its principal before it is due or if you get coupon payments before the bond matures, then you will be exposed to reinvesting at low rates.