Basics of bonds

Introduction

Bonds are financial instruments just like stocks. The main difference between these are that, bonds are debt as opposed to stocks which offer ownership. Bonds give out interest in the form of coupons. Bonds can be issued by government, corporations and various other institutions. Bonds have special characters and they are usually a safer investment option during a bearish market.

What are bonds?

Bonds are essentially IOU’s which means that the issuer is in debt to the bond holder. So what makes these bonds attractive are the interest amounts that they pay out called coupons. Bonds have a maturity date i.e. the day the bond repays the money. Bonds can be both long term and short term, maturity dates ranging from 1 year to 30 years.

Bonds are fixed income securities and unlike stocks the investor is certain to recoup their investment. However, there are risks involved with bonds as some bonds belonging to companies or unstable governments (Zimbabwe) may be unable to pay the money back. This is why bonds have credit ratings to give investors an idea if the bonds are of investment grade or not.

Credit rating agencies such as Moody’s, S&P, Fitch and many others have credit ratings which ranges from A to D. Although any bond with a credit rating of below B is considered junk bonds. These do not make investment grade and carry a huge risk of the issuer defaulting. However these bonds offer a higher yield to entice investors and so, many experienced investors opt for these bonds.

(Bond Ratings from Investopedia)

Bonds like other securities change in price every day. This might seem surprising given the fact that bonds are a fixed income security and investors get their principle amount back. However, bonds do not need to be held till maturity and can be sold at anytime in the bond market where prices change daily.

Yield

Yield is a figure that shows the return on bonds. The formula for this is:

Yield= Coupon amount/Price. If the bond price goes up then the yield decreases and if the bond goes down in value then the yield increases.

Types of bonds

As mentioned before bonds can be issued by governments and corporations. These vary in prices, maturity dates and quality. Bonds issued by the United States are said to be the best as the U.S government has an unlikely chance of defaulting. There are three types of government bonds:

Bills- Matures in less than a year

Notes- Matures from 1-10 years

Bonds- Matures in 10 years a above

Corporate bonds are issued by companies who wants to expand into new markets and new products and so need capital to do so. Blue chip companies have good quality bonds compared to companies that have less reputation. Corporate bonds are divided into:

Short term- Matures in less than 5 years

Intermediate- Matures in 5- 12 years

Long term- Matures in 12 years and above

Convertible bonds are hybrid securities and can be converted to stocks if the bond holder wishes.

Zero coupon bonds have no coupon but are sold at a discount and so effectively a £1000 bond which matures in 10 years are sold at £500 today. This means that in 10 years the bond will be worth £1000.

In conclusion bonds are similar financial instruments like stocks but with the added value of returns even in a bearish market and so investors who are risk averse may favour these over the more unpredictable stocks.