Investments in bonds can be quite tricky. Whether it is corporate bonds or government bonds, it is important to understand how they work, the risks involved and its ability to give the returns you expect as an investor.
Simply put, a bond is a debt security where the bond issuer, who is known as the borrower, issues the bond for purchase by the bondholder, who is known as the lender. Bonds involve borrowing money in form of a security and this is why they are also known as fixed income securities because they usually give the bondholder a regular or fixed return. As an investment tip, if anyone offers you guaranteed returns on investments that are not bonds, chances are that that investment is either a ponzi scheme or a flat-out scam.
When an investor decides to invest in a bond, it means they are essentially lending a sum of money to the bond issuer and in return, and investor is usually entitled to receive what are called coupons, which are interest payments on their bonds, at scheduled intervals and capital repayment of your initial principal amount at an agreed date in the future, known as the maturity date.
As we always say at Nairametrics, before making any investment decision it is important for any investor to do a self-assessment of the risks involved. Doing a self-assessment involves a lot of things but a major check is understanding the risks associated to the investment vehicle itself and identifying the risk threshold of an investor.
Once a self-assessment is done, an investor can easily decide on an investment strategy that works out after considering their overall target return on investment and potential cost of risk. This is crucial when deciding to invest in high-yield bonds, investment-grade bonds, government bonds or a mix of all.
Key facts to know about Bonds
- The bond market may seem unfamiliar even to the most experienced investors. Many investors make only passing ventures into bonds because they are confused by the apparent complexity of the market and the terminology.
- Unlike stocks, bonds can vary significantly based on the terms of their indenture. An indenture is a legal document that outlines the characteristics of the bond. Because each bond issue is different, it is important to understand the precise terms before investing.
- Bond yields are all measures of return. Yield to Maturity (YTM) is the measurement most often used. This method measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate. It is important to note that because it is unlikely that coupons will be reinvested at the same rate, an investor’s actual return will differ slightly.
- A bond can be secured or unsecured. A secured bond pledges specific assets to bondholders if the company cannot repay the obligation. Think of them as collateral on loans because in a situation where the bond issuer defaults, the asset is then transferred to the investor.
- Unsecured bonds, on the other hand, are not backed by any collateral. That means the interest and principal are only guaranteed by the issuing company. In the bond market, they are usually called debentures. These bonds return little of your investment if the company fails. As such, they are much riskier than secured bonds.
- When a firm goes bankrupt, it repays investors in a particular order as it liquidates. After a firm sells off all its assets, it begins to pay out its investors. Senior debt is debt that must be paid first, followed by junior debt. Stockholders get whatever is left.
- Some bonds can be paid off by an issuer before maturity. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. A company may choose to call its bonds if interest rates allow them to borrow at a better rate. Callable bonds also appeal to investors as they offer better coupon rates.
- While bonds may be considered by many a safer investment, compared to other investment vehicles, this is not entirely true. There are a lot of risks associated with bonds which includes; interest rate risk, default risk and prepayment risk.
- Most bonds come with a rating that outlines their quality of credit. That is, how strong the bond is and its ability to pay its principal and interest. Ratings are published and are used by investors and professionals to judge their worthiness.
- Ratings of bonds are done by credit rating agencies like Augusto and Co Limited, DataPro Limited, Global Credit Ratings Co Limited and so on.
Are Bond investments right for you?
Yes, investing in bonds is considered to be safe. However, as investors, we must look at several factors before making investment decisions and even throughout the time we hold the bond so that our investments are safe at all times.
A bond investment is usually seen as a way to strengthen a portfolio’s risk-return profile. This is because adding bonds help create a more balanced portfolio by adding diversification and calming volatility compared to other investment vehicles like stocks or crypto.
It is also important to highlight that bonds provide a predictable income stream. Typically, bonds pay interest twice a year and if the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing. Although this can be limited as committing to a fix interest rate could be a bad investment, especially when considering the possibility of a high inflationary environment.
Considering these factors, we believe that in order to maintain a diversified investment portfolio, including bond investment is very essential.
