Making a long-term investment in bonds allows you to have a plan for your future. There are however certain risks involved and if you are planning a retirement fund you must know all the details and risks associated with bonds. Bonds are a sort of investment offered by the government to citizens at a fixed rate of interest. In this type of investment, a lender lends money to a company or a government institution for a specific timeframe. Bonds offer regular payments in some cases, and in others, they have a maturity date. By the time the maturity date ends, the government or the company pays the face value or original value of the bond.
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A brief overview of bonds
Bonds are issued in all forms because they provide stability to both the creditor and debtor. The term "fixed income" is mainly used to describe bonds. It is because the investment earns fixed payments over the life period of the bond. The price of the bonds can change with the changing economy. If a government or a company that sold the bond is doing well and bonds are becoming popular, then the price of the bonds will increase. It also means that the interest rates offered to the buyer of the bond will also change. The interest rates of government bonds change based on the market value. If the bond yield is high, then the interest rates will drop. In a fixed interest rate bond, the interest will remain the same throughout the length of the bond.
Why do bonds exist?
Companies can be seen selling bonds to finance new projects or ongoing operations. On the other hand, governments sell bonds for funding and financing purposes. Investing in a bond makes you a debtholder or a creditor for the institution issuing the bond.
There are several types of bonds, some with high risks and others with lower risks. The person buying the bond can select the kind of bond according to their needs and help them maintain a well-rounded investment portfolio.
How do bonds work?
Bonds are a way to invest that involves an agreement between parties. The borrowing entity promises to pay the bond back within a specific timeframe. During this time, the borrower pays interest payments to the bondholder according to the agreement between the two parties. People who own these bonds are called debt holders or creditors. Clipping coupons redeemed the interest payment in previous times, but the entire process is now done electronically.
The principal or the initial amount is called the face value, and the debtor has to repay this amount when the bond matures. Most bondholders tend to resell these bonds before they reach their maturity stage. This can only be done because there is a secondary market for bonds. There are two primary ways of trading bonds. The first method is to trade bonds on exchanges publicly, and the other way is to sell them privately between the creditor and a broker.
Bonds: Terms to understand
Before we move forward and get into the complex structures and characteristics of bonds, let's look at some essential bond terminologies that need to be understood before selecting a bond.
Maturity
Maturity is the length of the time in which a bond will remain viable. The end of the maturity date is like an expiry date where the term of the bond will end. A bondholder will get the face value of the bond after the maturity date. If the bond has a fixed interest for example, if there is a 2% interest rate on a bond that has a £500 face value, then the bondholder will get £10 throughout the maturity period of the bond. If the interest rate is not fixed then the interest paid along the maturity period will vary. This variation will be based according to the market rate.
All bonds have a lifetime. The term of the bond depends entirely on the type of bond. This lifetime can last anywhere from one month to almost 50 years.
Convertible Bonds
A bond that can be doubled as an investment is called a convertible bond. The bondholder can change the value of the bond by converting it into a share or a stock. He or she can change the bond into stocks and back to a regular bond throughout the maturity period. In this case, there is a specified time when and at what price these bonds can be converted into stocks. Convertible bonds usually have a lower interest rate, but higher earnings can be earned once converted into stock. The interest rates keep changing according to the market fluctuations and the profits obtained by the company giving out the bond.
Callability
This term refers to the power of a company or agency to call the bond back at a particular time of their choice. In simpler words, the company has the right to repurchase the bond before it matures. An agency is expected to do this when interest rates are falling to issue new bonds at lower rates and save money. This deal can turn out to be profitable for those who bought the bonds because of the extra premium added to the face value of the bond.
Secured Bonds
Secured bonds are lent on a particular asset. These types of bonds are backed by collateral. This means that the company that issues these bonds has assets and money to cover the initial value of the bond. The bondholder can claim an asset from the company or the government giving out the bond. Assets include tax payments in case of government bonds, property, or cash flow from a project. The first mortgage on a property can also be used as an asset. If the company or agency goes bankrupt, the money or assets will be given to people who bought the bonds.
Unsecured Bonds
Unsecured bonds are handed out on faith rather than an asset. They are also called debentures. When a company does not have proper assets it can issue unsecured bonds. Giving bonds a highly volatile nature, unsecured bonds allow credit rating agencies to measure the validity of a company or a government. Unsecured bonds allow bonds a value above the normal financial status and help brokerage companies communicate effectively with both creditors and debtors. But these are not suitable for individual investors.
Put Provision
A bondholder has the choice of selling a bond back to the bond issuer before it reaches its maturity. A put provision allows you to sell your bond at face value. In callability, a bond issuer can take the bond back before it provides yield to maturity.
While this can be done at any time, the seller still needs to schedule and provision ahead of time. Many individuals who own bonds put their bonds when interest rates rise, so they earn more money by investing it.
Four types of bonds
Although there are many different types of bonds, four main types of bonds are issued by governments and different organizations. Let's take a look at these categories.
Government Bonds
Government bonds are also known as sovereign bonds. These bonds are the primary way for the government to borrow money to fund various initiatives. These initiatives can include funding infrastructure projects as well as controlling the nation's money supply. Periodic interest payments are made throughout the duration agreed by both parties. Moreover, the initial sum borrowed is returned at the bond's maturity.
Government bonds are affected by the following factors:
- Political stability
- The creditworthiness of the country
- Macroeconomics
Government bonds are a much safer investment in the UK, but this investment type might be risky somewhere like Italy.
Pros and cons of Government Bonds
Government bonds have various pros and cons. On the brighter side, mostly debt securities tend to return a steady stream of interest income. But the returns are not extraordinarily high and usually lower than the other products on the market. The main reason behind lower interests is the reduced level of risks involved in these types of investments.
The pros of government bonds include:
- Exemptions from local taxes
- Lower risk of default
- Steady interest income return
- Liquid market allowing smooth reselling
- Assessable through ETFs and mutual funds
The cons are listed below:
- There are higher risks attached to foreign bonds
- Offer low rates of return
- Risk increases with an increase in interest rates
- Rising inflation leads to a fall in fixed income
2. Corporate Bonds
A corporate bond is offered by a company trying to increase its revenue. It can be a fixed rate bond or an interest-based bond. The company gets some money for its bank account and the investors get regular payments until the bond reaches its maturity. A company can establish a fixed coupon rate for a bond and pay the interest rate to the bondholder until it reaches maturity.
Companies mainly issue corporate bonds. The purpose of issuing these bonds is to raise money for things like:
- Capital expenditures
- Acquisitions
- Operations
Corporate Bonds are not stocks
Corporate bonds, also known as corporates, are issued by all kinds of businesses. You need to understand that bondholders don't receive any ownership rights in the corporation, unlike equity stockholders. They do, however, get the equivalent of an IOU to form the bond's issuer. In case the corporation goes bankrupt or is liquidated, the bondholder will receive some of their investment back.
When an entity purchases a bond, they lend money to the company that issued it. After this, the company ensures to return the money on a specified date when the bond is entirely mature. During this time, a stated rate of return is paid semiannually. Keep in mind that payments collected from corporations are taxable.
3. Municipal Bonds
Municipal bonds are also known as Munis. These bonds are debt securities issued by government institutions. The purposes of these bonds are to fund daily obligations and finance projects such as building drainage systems, schools, and highways.
When a municipal bond is issued, the receiver promises to submit interest payments regularly or face withdrawals. These payments are usually made semi-annually. Another thing about this bond is that the maturity date of these bonds may be years in the future. This gives you some breathing room to get enough money to return the initial amount. The maturity duration of short-term bonds is one to three years, whereas, for long-term bonds, it is more than a decade.
Why choose a Municipal Bond?
The good thing about municipal bonds is that generally, they are exempt from federal taxes. There is a possibility that the interest may also be exempted if you live where the bond is issued. This type of bond has several tax benefits for the bondholder. The interest income you receive from investing in a municipal bond is free from federal income taxes, to name a few benefits. Furthermore, the interest income you receive from securities issued by the government units is also exempt from local taxes and offers stability.
Moving forward, we explore the two most common types of municipal bonds below.
Revenue Bonds
The government's taxing power does not back these bonds. Instead, they are backed by revenues from a specific project or initiative. This can include lease fees or high tolls. Furthermore, the bondholders cannot claim the underlying revenue source if the revenue stream dries up. These revenue bonds are non-recourse.
General Obligation Bonds
Cities, states, or counties issue these bonds. Moreover, they are not secured by any assets. The general obligation is backed by the full faith and credit of the bond issuer. This obligation has the power to tax citizens to pay bondholders.
- Municipal bonds are tax-free, which means that investors are not required to pay any tax on these bonds.
- The government is responsible for the repayment of the initial amount and the interest value of these bonds after their maturity.
- These are debt securities which means this is the debt that the investors give to the government.
4. High-Yield Bonds
High-yield bonds are offered by companies that need to improve their financial credibility. They offer high-interest rates that allow companies to enhance their position on the stock market. They are like corporate bonds because both of these bonds represent debt issued by a firm. The bonds are issued with the promise to pay interest and the initial cost at the time of maturity. But the significant difference between these bonds is the issuers' poor credit quality in high-yield bonds.
High-yield bonds are divided into two different categories.
Rising stars
If a company begins to repay its debts then it is called a rising star. When people start investing in rising stars, they are more likely to get high-yield bonds. This bond may still be a high-yield or junk bond, but it's on the way to being investment quality. It means that the company has stabilised itself over time and can save itself from withdrawals. It also indicates that the company has earned high credit ratings on its debt issues.
Fallen angels
If a company has lost its credibility because of poor financial choices it is most likely to give out high-yielding bonds. That is why they are named fallen angels. This is the kind of bond that was once of high investment quality, but the status of this bond has been reduced to junk or high-yield bond.
The advantages of high-yield bonds include increased expected returns and higher yields. On the other hand, the disadvantages are higher volatility, withdrawals, and default risks.
General pros and cons of bonds
Bonds are a type of investment that involves an agreement between parties. It can be difficult to choose which bond will be best suited for your company, home, or business. Bond funds can have various pros and cons.
Benefits and drawbacks for investors
The primary reason for purchasing bonds is to generate income on the amount invested. As mentioned before, government and municipal bonds carry tax benefits on their interest payments. These types of fixed-income investments allow investors a high level of predictability when planning for future cash flow. Another significant advantage of bonds for the investors is that there's no risk to the principal in bonds like municipal bonds.
Now coming towards the disadvantages, inflation can diminish the power of fixed interest payments over time. Another significant disadvantage is that issuers can build call features into their bonds. This gives immense power to the issuers over the investors. The issuers can retire bonds at a preset date and price before maturity if current market rates are lower than the interest paid on a bond.
Benefits and drawbacks for issuers
Let's talk about the issuers' benefits and concerns from investing in bonds. The great thing about government and municipal issuers is that bonds offer them access to capital above the revenues collected via local, state, and federal taxation. The issuance of bonds is favored over increasing income taxes by taxpayers and politicians. Furthermore, the interest payments on bonds are tax-deductible, and the corporations offer access to capital without altering the ownership that accompanies selling shares in the company.
On the contrary, there are many disadvantages for the issuers. The first one is that the bonds are structured to pay a fixed level of interest until maturity. In this scenario, if the interest rates decline after the issuance of the bond, the issuer is required to pay the same amount of interest despite a decline. The bond issuer will be stuck paying above the market rates. Another apparent disadvantage is that an expanding level of debt can majorly increase the risk related to the issuer. With more money comes more risk, which can force issuers to pay higher interest rates.
Types of bond risk
There are various advantages of investing in bonds. Bonds are considered a safe investment. There are however some risks involved in bonds.
Inflation risk
Inflation rates are unpredictable, and there is always a chance that the governing body will enact policies that will lead to inflation impacting the purchasing power. A high rate of inflation will eventually impact your purchasing power. There are exemptions if you own a variable-rate bond or if the bond has in-built protection. By the time you have your initial sum back, the inflation rate might be so high that the essential goods and services are much higher than you expected.
Credit risk
This risk is associated with when the issuer cannot pay the face value or the interest payment within the time frame. This can be problematic if you do not receive your promised amount. You can get a high-yielding bond to cover the cost of withdrawals or a put provision.
Liquidity risk
We talked about the bond market's liquidity and how easy it is to sell and resell bonds, but not all bonds are liquid; some are far less liquid than blue-chip stocks. This means that once you get these bonds, it might be hard for you to resell them at a top dollar. You can choose an unsecured bond if you do not see yourself investing in the long term. If on the other hand, you need financial support, you can go for a secured or corporate bond.
Reinvestment risk
Last but not least, we have reinvestment risk, which involves the unpredictability of the actual rate at which you will be able to reinvest the money. You know that your bonds will be sending you interest income regularly. If by any chance, the interest rates drop considerably, you will be required to put your new interest income to work in bonds yielding much lower returns than you have been receiving before.
Bonds as an investment
Bonds have the potential to be a lucrative investment vehicle as you progress towards retirement. However, you must have an appreciation of both the potential pros and cons of investing in bonds, including in specific types of bonds, to ensure you’re able to make decisions suitable for your needs.
Speak to an independent financial adviser to get professional guidance on investing in bonds.
