Who has a problem in having some extra money in his kitty. People invest money in various schemes like bonds, stock markets etc to gain that extra amount. Stock markets seem to be the most popular choice among the investors. And so are the bonds and other financial schemes.
Let’s understand what are bonds, various kinds of bonds, their characteristics and other information related to bonds in the following sections.
Following statements define what a bond is:
Following points describe the process of bonds:
|Types of Bonds|
|Fixed Rate Bonds||Book-Entry Bond|
|Floating Rate Notes||Lottery Bond|
|Zero-Coupon Bonds||War Bond|
|Inflation Linked Bonds||Serial Bonds|
|Asset-Backed Securities||Revenue Bonds|
|Subordinated Bonds||Corporate Bonds|
|Bearer Bonds||Extendible / Retractable Bonds|
|Municipal Bond||Government Bonds|
Bonds can be classified in the following categories:
Corporate Bonds are issued by private companies. It depends on the company to decide the amount that they want to issue. There is a lot of risk involved in a corporate bond as the chances of a company being a defaulter is more. Due to this reason, there is a high yield in a corporate bond.
On the other hand, corporate bonds have an advantage also and that is they are the most rewarding fixed-income investments as the risk associated with the bond is also high.
Furthermore, corporate bonds can be:
Municipal bonds are issued by the government bodies like Treasuries etc. These bonds come at the next level after the corporate bonds as far as the risk involved is concerned as the cities don't get bankrupted that often. An advantage of municipal bond is that the returns are free from federal tax. Apart from this, sometimes, local governments make their debt non-taxable for residents, thereby making municipal bonds fully tax free. Due to this reason, yield on a municipal bond is comparatively lower than that of a taxable bond.
Then there are bonds that are specifically long-term investments having maturity period more than ten years.
It is very important to know the terms and terminologies related to Bonds to understand them better. In determining the value of a bond following are the factors which play a vital role.
a) Face Value/Par Value: Also called as “Par value” or principal, this is the amount that a holder gets back on the maturity of a bond. A newly issued bond is usually sold at the par value. Corporate bonds usually have a par value of1000 USD, but government bonds may have even more face value.
b)Coupon (Interest Rate): It is the amount that the bondholder receives as interest payments. However, these days, records are kept electronically.
Most bonds pay interest every six months, they can also pay monthly, quarterly or annually.
c) Maturity: refers to the future date when investor's principal would be re-paid. This may vary from as little as a day to as long as 30 years. Bonds that mature in one year are more predictable and hence less risky than the ones that mature in longer tenures. Hence, time to mature for the bonds is inversely proportional to the rate of interest. Moreover, bonds with longer tenures fluctuate more than the ones with shorter tenure.
d)Issuer: refers to the entity who is issuing the bonds. It plays an important role as stability of the issuing entity determines the assurance of getting the amount paid back. Generally government bonds are more stable as the chances of the government getting bankrupt are very less. On the other hand, company bonds are least stable.
e) Bond rating System: While importance of issuer is being talked of, it is equally important to understand the bond rating system that helps the investors to determine a company's credit risk. Bond rating can be considered as the report card for a company's credit rating. Companies that are well-off in terms of investments, have a high rating, while the ones that are not financially sound have a low bond rating.
Many people get confused with the thought that the price of bonds changes daily like that of the shares. It is also not necessary that a bond has to be held till the time of maturity. So it becomes important to understand the concept of yield to how price changes.
Yield refers to the return amount that you get on a bond. It can be calculated using the following formula:
Yield = coupon amount/price.
Yield changes with the price of the bond.
Generally, yield is referred to as “Yield to Maturity” which essentially means the total return you will receive if you hold the bond till the time of maturity.
Yield and price are inversely proportional to each other. When price goes up, yield goes down and vice versa.
Interest rates also influence price and yield of bonds to much extent. Rise in the interest rates leads to fall of the prices of bonds thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons and vice versa.
Having learnt about the bonds in detail, the question now arises – how do I buy bonds?
With the help of full service or a discount brokerage most of the bond transactions can be completed. An account can also be opened with a bond broker but it depends on the minimum amount that the broker expects. Some financial institutions even provide a service of transacting government securities.
In a nutshell, bonds do provide a long term reliable investment provide you understand the details carefully.