Portfolio balancing, negating stock market volatility and lowering risk
Bonds have historically been an alternative way to balance a portfolio and negate stock market volatility, and they are treated as lower risk. The art of investing is all about mixing assets to build a portfolio aligned to your investment outlook and attitude to risk, with shares and bonds as primary components. For investors, bonds can provide a stream of returns.
A bond is an IOU, typically issued by a government or company (an ‘issuer’). Companies issue bonds to meet their expenditure or to settle out their debts. Governments also issue bonds in order to settle any financial deficits of the government, and also to bring development. When issued by a company, they are referred to as ‘corporate bonds’. By buying a bond, you are lending the issuer money. Two things are specified at the outset: the agreed rate of interest that the issuer must pay you at regular intervals (the ‘coupon’), and the date at which the issuer must repay you the original amount loaned (the ‘principal’).
Making different market assessments
Bonds can be bought and sold in the marketplace. Their prices change constantly because people in the market make different assessments on two main factors: the likelihood that the issuer will repay its debts (‘credit risk’), and the effect of interest rates (‘interest rate risk’).
If more investors want to buy a bond than sell, the price normally increases. Similarly, if there are more sellers than buyers, the price normally goes down. The rising or falling price affects the yield of the bond. Yield is a way of measuring the attractiveness of an individual bond. However, bonds are not always held until the principal is repaid – they can be bought and sold at any time until the principal is repaid – so there are many ways of calculating the yield. The most common is the ‘redemption yield’. This discounts the value of coupons received over time. It also adjusts for any difference in the price paid for the bond and the principal repaid at maturity.
Generally stable regular income
Bonds pay investors a regular income, and their prices are generally stable. They are also generally considered safer than equities and are issued by reputable companies or governments. Should a company that has issued bonds run into financial difficulty, the bond holders rank ahead of equity holders for repayment. However, the price of a bond can fall as well as rise, and there is no guarantee that an issuer will not default on its obligations. The effects of interest rates and inflation can also erode the future values of returns.
Investors demand a premium for the extra risk they are taking when lending money to a less well-established company or less creditworthy government. Therefore, bonds from these issuers tend to be higher yielding. Comparatively well-financed issuers are referred to as ‘investment grade’, while less secure issuers are referred to as ‘high yield’ or ‘sub-investment grade’. Different types of issuers are affected in different ways. For example, government bonds tend to be more affected by changes in interest rates, while corporate bonds are more affected by the company’s profitability.
Bond investments not right for everyone
Like any security, there are many options when it comes to bond investments, and they are not right for everyone. Various types of bonds can be issued. These include inflation-linked bonds, where payments are linked to changes in inflation, and convertible bonds, which are corporate bonds that can be converted into the company’s underlying equity. Certain types of bonds may be better suited to particular economic conditions or meeting particular investment objectives.
A credit rating can be given to an issuer, either to one of its individual debts or overall creditworthiness. The rating usually comes from credit rating agencies, such as Moody’s, Standard & Poor’s or Fitch, which use standardised scores such as ‘AAA’ (a high credit rating) or ‘B-‘ (a low credit rating).
Considering economic and technical factors
Inefficiencies in the bond market cause potential returns available from one bond or sector to outweigh each other at different times. By carefully researching the issuers in the market, as well as considering economic and technical factors, bond fund managers aim to manage portfolios of bonds that suit the current investment conditions.
How bond fund managers perform is typically measured against an index of bonds in the region or type of issuer in which they invest. This is known as a ‘benchmark’. The fund manager will aim to outperform the benchmark, as well as protect investors’ capital when the wider market is falling.
Face Value/Par Value
The par value or face value is a term used to define the principal value of each bond, which means the amount you had paid while purchasing the bond. The amount that you paid while purchasing the bond is the exact amount that you should expect in return once the tenure of the loan is completed.
The maturity date of a bond is the date on which the bond validity expires, and the company or government that issued you the bond should pay you back the entire face value or par value at the end of the maturity date.
A coupon is the annual interest amount in percentage that you will be receiving for the face value of the bond.
The yield of a bond is the percentage of annual interest that you get paid for your bond depending on the current market value of the bond you purchased.
Investments in terms of bonds are generally made by taking the bond investment grade into consideration. The bond investment grade can be considered as the score of a company depicting how likely the company is to pay back your bond after the end of the maturity date.
The investment grade for each company is offered by different agencies such as Moody’s, Fitch and Standard & Poor. In order to be considered trustworthy for buying bonds from, any company should have at least a rating of ‘BBB’. The companies with a ‘BBB’ grade rating are highly likely to pay back your investment amount after the maturity date and are safe bond investments. The companies that have a rating of ‘BB’ or lower are considered to have a ‘junk grade’ and is not at all recommended while buying bonds.
INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.
THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.
PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.