Bonds are a common investment. However, to many investors, they remain a mystery. So let’s explore what a bond is and how it might benefit your investment portfolio.
What is a Bond?
A bond is a loan given to a company or government by an investor. By issuing a bond, a company or government borrows money from investors, who in return are paid interest on the money they’ve loaned.
Why do companies and governments issue bonds?
Companies and governments issue bonds frequently to fund new projects or ongoing expenses. Some investors use bonds in hopes of preserving the money they have while also generating additional income.
Bonds are often viewed as a less risky alternative to stocks and are sometimes used to diversify a portfolio.
How do bonds work?
Consider this example. The city of Johannesburg wants to build a new football stadium, so it decides to issue bonds to raise money. Each bond is a loan for R10,000.00, which Johannesburg promises to pay back in 10 years.
To make this loan more attractive to investors, Johannesburg City agrees to pay an annual interest rate of 5%, which in the bond world is also known as a coupon rate. An investor buys the bond at face value for R10,000.00.
Now, let’s fast forward. Each year the city of Johannesburg pays the investor R500.00. These regular interest rates continue for the length of the bond, which is 10 years.
Once the bond reaches maturity, the investor redeems his bond, and Johannesburg City returns its R10,000 principal investment. This bond was a good deal for both the city and our investor.
The City of Johannesburg got the money it needed to build the stadium. The investor received regular interest payments and the return of the original investment. Because a bond offers regularly scheduled payments and the return of invested principal, bonds are often viewed as a more predictable and stable form of investing.
Who issues Bonds?
In South Africa bonds are issued by the national government, provincial governments, municipalities and corporations. When thinking about the credit worthiness of a bond, it’s important to consider the issuer behind the bond.
More specifically, it’s important to understand how an issuer earns money to make interest payments and pay back the principal.
To help you understand this, let’s examine the South African government. Consider a 10-year bond or note issued by the South African government. Backing this 10-year note is the government’s ability to levy and collect taxes.
For the South African government, collecting taxes isn’t much of an issue, so they’d likely have no trouble paying interest payments on this bond. Also, taxes are collected regardless of how the overall economy is doing.
So even in rough economic times, the South African government is more likely to be able to meet its obligations and pay interest on time and in full.
Now, let’s compare this to a company. Suppose a company decides to issue a 10-year bond. This 10-year bond is backed by the corporation’s earnings and assets.
But unlike the steady stream of money from taxes, a company’s earnings and the value of its assets can change dramatically.
These changes might be due to swings in the broader economy or they might be due to a new competitor entering the market. In other words, a company has higher credit risk.
This is the risk that they could miss a coupon payment or not be able to return the principal to the investor. This is why investors and rating agencies typically perceive government bonds as less risky than corporate bonds.
Municipality bonds tend to fall in the middle. Like the central government, municipalities raise money through taxes. However, cities have a much smaller tax base. Cities also don’t have the same economic resources as the central government when times get tough.
Therefore, municipal bonds are perceived as riskier than government bonds. But in the investing world, there is a trade-off between risk and return.
The same applies to the world of bonds. Bonds issued by riskier entities tend to offer a higher yield, while others issued by safer entities tend to offer a lower yield.
For example, we could have two nearly identical bonds, both have a triple-a rating and a 10-year maturity. The only difference is one is issued by a corporation and a government issues the other.
The corporate bond would likely offer a higher yield because a corporate bond carries more risk. Issuers with lower creditworthiness usually offer higher interest rates to offset increased risks, and these differences in risk have a lot to do with the sources of money backing the issuers.
Stocks vs Bonds
Compare regular payments of a bond to the experience of owning a stock. With stocks, profits and losses are driven by market forces and are generally less predictable. Of course, like any investment, bonds are not without risk.
Bond Default Risk
Default risk is the possibility that the bond issuer defaults on paying back the principal. Typically, bonds with higher default risk also come with higher coupon rates. The amount of risk depends mostly on the financial stability of the issuer.
For example, most governments are generally considered stable issuers and issue bonds with a relatively low coupon rate. Corporate bonds typically represent a greater risk of default, as companies can and do go bankrupt.
As already explained above, that’s why corporate bonds often offer a higher coupon rate. Several credit rating agencies assign rankings to different bonds. This can help bond investors to gauge the financial strength of the bond issuer.
These rating agencies often use different criteria for measuring risk. So it’s a good idea to compare ratings when considering a particular bond. And keep in mind, rating agencies aren’t always accurate.
So be sure to research a bond and its risks thoroughly before investing. Another risk to consider as interest rate risk. This is the risk that interest rates will go up and any bonds you own will be worthless if sold before the maturity date.
After all, when interest rates rise, more investors allocate their money into the new, higher interest rate bonds. If you wanted to unload a low-interest rate bond to take advantage of these new rates, you would have to sell your bond at a discount to make it a worthwhile purchase for another investor.
Capital preservation and income generation are just two ways bonds might be part of a diversified portfolio. Many investors use a mix of stocks and bonds to pursue their investment goals.
And because bonds moved differently from stocks, they can help increase or protect portfolio returns. Keep in mind that this discussion showed you one simplified way that investors might use bonds and only a few of the risks to consider.
Like all investments, bonds are complex and have a variety of uses and risks. Before you invest in bonds, it’s important that you invest in your own financial education.