Bonds 101: Understanding Your Investment Options
Have You Ever Heard Someone Say Bonds Are a Safe Bet?
While they are often seen as safer investments compared to stocks, bonds still come with their own set of risks. Investors should approach an investment in bonds with an open mind, focusing not only on the rate of interest (also referred to as coupon) but also giving weight to other variables.
Keep reading – whether you’re a curious newbie or just looking to brush up, we’ve got you covered.
What Are Bonds?
When you buy a bond, you’re basically lending money to a company or government. In return, they promise to pay you interest and give your money back after a set time.
The Good, The Bad, and The Risky
Benefits of Bonds:
- Regular Income: Bonds usually pay interest at fixed intervals
- Diversification: Including bonds in your investment portfolio can help reduce overall risk.
- Low Risk: Potentially lower risk than stocks (but not risk-free!)
- Preservation of Capital: If held to maturity, bonds can return your initial investment, barring defaults
Risks of Bonds:
- Interest Rate Changes: These can affect bond values. Bonds with higher interest rates are generally considered riskier. So, while you might earn more, there’s a chance you won’t get your full investment back
- Credit Risk: The issuer might struggle to pay you back
- Inflation: Inflation can eat into your returns
Important Bond Terminology
Secured vs. Unsecured vs. Guaranteed Bonds: How protected your investment is if things go south. Secured bonds are backed by assets, so you’re more likely to get your money back if the issuer defaults. Unsecured bonds come with higher risks there are no specific assets backing them up.
When bonds are guaranteed, it means that a third party promises to pay if the issuer can’t.
Maturity: When the bond issuer pays back your original investment.
Yield to Maturity: This is the total return you’d get if you held the bond until it matures, including interest payments and any gain/loss based on the purchase price.
Coupon: The annual interest payment on a bond.
What You Need to Know – Frequently Asked Questions
Will I Definitely Get my Interest Payments?
Nothing’s guaranteed, but some bonds are rated by agencies to give you an idea of the risk. Local bonds often don’t have ratings, so do your homework well! Check out the issuer’s financial health and read the prospectus, before investing.
How Can I Tell Which Bonds are Riskier?
Generally, the higher the interest rates, the higher the risk.
What Else Affects Bond Interest Rates?
The interest rate on a bond, or coupon, is influenced by several factors:
- Credit Quality: Riskier issuers must offer higher interest rates to attract investors.
- Market Conditions: Supply and demand dynamics can affect bond prices and yields.
- Economic Indicators: Inflation rates and central bank policies can also influence interest rates.
- Maturity: How long until the bond matures.
When interest rates rise, bond prices typically fall, and vice versa. This relationship is crucial for investors to understand, especially if they plan to sell their bonds before maturity.
Is Principal Repayment Guaranteed?
Not all bonds guarantee the return of your principal, but some bonds are safer than others. Always check if a bond is secured. Secured bonds offer better protection since they are backed by assets. In contrast, unsecured bonds carry higher risk, especially if the issuer faces bankruptcy.
Key Takeaway Pro Tips
- Always read the prospectus – it’s your bond’s instruction manual.
- Don’t just chase high interest rates – understand the risks.
- Consider talking to a financial advisor for personalised advice.
