by Deepthi Sai
The term ‘bonds’ surfaces every now and then in discussions pertaining to the economy. You may have read about a company or the government ‘issuing bonds’ often. This article aims at elucidating the jargon associated with bond markets.
A bond signifies a promise to return a borrowed sum at a later date. It is nothing but an instrument of indebtedness or a loan. It is often called an IOU, abbreviated from the phrase ‘I owe you.’ The borrower of the money issues the bond and hence is called the issuer of the bond (or debtor) and the lender of the money is called the holder of the bond (or creditor). At the time a bond is issued, an interest rate is stated. The interest on a bond is called a coupon. The issuer of the bond is obligated to return the borrowed sum along with the coupon within a certain period of time or before the maturity date.
The price of a bond and the interest rate are inversely related i.e if bond prices increase, interest rates fall and vice versa. This relationship might seem odd at first. To understand it, consider a simple example. Let Company A issue a bond priced at $1000 which earns a 5 percent interest rate (i.e., $50) every year. Now suppose that bonds that are similar in nature start paying 8 percent interest. Thus, the market interest rate for bonds similar to that issued by Company A increases. Now, would any investor pay $1000 to Company A to earn a 5 percent interest when they can buy a similar bond for the same $1000 and earn 8 percent (or $80) on it? Probably not. Since no one wants to buy Company A’s bonds anymore, Company A will lower the price of their bonds. This illustrates the inverse relationship between bond prices and interest rates.
What sets bonds apart from stocks is the fact that they can vary with the terms of the indenture. An indenture is a contract between the issuer and holder which outlines features of the bond (maturity date, interest rates, amount to be repaid, etc). Since the terms on the indenture govern the features of the bond, investors tend to scrutinize every bond separately before making investment choices.
A bond can be secure or insecure. A secured bond is always backed by some asset so that if the issuer defaults, the holder of the bond may still recover a part of his money. For instance, a bond backed by a mortgage will be considered secured. Repayment in case of an unsecured bond (or debenture), on the other hand, depends on the credibility of the issuer. For instance, a bond issued by the Government of India is unsecured because the government does not pledge any asset to the creditor in case they fail to repay the money borrowed. In this case, the investor can choose to invest or not depending on the debtor’s probability of defaulting.
An attractive investment option is the tax-exempt bond. As the name suggests, these bonds are exempt from taxes, i.e., the gains from these investments are not subject to a tax. Most tax exempt bonds tend to be government or municipal bonds. Since the investor is exempt from paying tax, the return on these bonds tend to be lower than corporate bonds and other taxable bonds. An investor calculates his return from bonds after having to pay tax and that from tax-exempt bonds. He makes his investment decision based on where he expects a higher return.
With any financial asset come some associated risks. For one, a debtor may not pay the money he owes the creditor. This is called a credit risk or a default risk. Finding a credible borrower isn’t the only obstacle an investor may have to overcome. Market fluctuations very often influence returns which make investing a gamble. After having invested in a bond, there is a chance that conditions in the market will cause interest rates to fall. If this happens , the investor may get a lower repayment than what he expected. This is called an interest-rate risk. Taking advantage of this, the debtor might choose to repay the money before the maturity date. This is called the pre-payment risk.
Agencies such as Moody’s and Standard & Poor’s rate bonds based on the debtors ability to repay its loans (see also: Understanding Credit Ratings). Debtors can be classified as:
- AAA to Aaa: “high grade” or very likely to repaid;
- BBB to Baa: “investment grade” or unlikely to default ;
- BB to Ba or below: “junk bonds” or likely to default; and
- D: currently in default.
Bonds can be extremely useful in the sense that adding bonds to one’s financial portfolio improves diversity among an investor’s assets, calms volatility associated with financial markets and is relatively less risky. This is probably why financial advisors recommend that 45 percent of an investor’s portfolio should constitute bonds. Thus, despite all the intricacies associated with bonds, it still is an excellent investment option.
References
"5 Basic Things To Know About Bonds." 5 Basic Things To Know About Bonds. Investopedia, 19 Dec. 2010. Web. 17 Nov. 2012. <http://www.investopedia.com/articles/bonds/08/bond-market-basics.asp>.
"Secured and Unsecured Bonds." Bonds 100. Morning Star News, n.d. Web. 17 Nov. 2012. <http://news.morningstar.com/classroom2/course.asp?docId=5404>.
Thune, Kent. "Where to Invest 2012 - Bonds." About.com Mutual Funds. About.com, n.d. Web. 17 Nov. 2012. <http://mutualfunds.about.com/od/wheretoinvest/a/Where-To-Invest-2012-Bonds.htm>.
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