Bonds are touted by many as a low, almost no, risk investment. You put money in, and money comes out. Easy. But is it? As with any type of investment, you should understand how things work, because, as with all things finance, not all bonds are created equal.
“It’s true that, in general, bonds are a safer investment option,” explains Richard Cayne of Meyer International. “But there are many different types of bonds that offer different risks and returns.”
A bond basically is a loan. Entities that want to raise money may choose to issue bonds rather than going to a bank for financing or by issuing shares. There are many reasons for a company to go down this path, but, for the investor, it is generally a straightforward transaction. A bond represents a principal amount (its par value) that will be repaid at the end of set time period (its maturity date) with the issuer possibly paying interest (its coupon rate) at set intervals. Much like a loan.
Types of bonds
Bonds can be grouped by the type of issuer and the type of interest. Governments issue bonds – this can occur on an agency, state/provincial, municipal, or national level. And companies issue bonds, usually because they don’t want to dilute their corporate value with more shares.
Interest rates include fixed, floating, and indexed. Fixed is self-explanatory; floating often is a set rate plus a benchmark rate. Indexed rates are tied to indicators such as inflation rates or consumer price indices.
While these may seem simple categories, issuers can create quite complex structures within bond terms, such as mortgage-backed and convertible bonds.
Bond risks and returns
While some investors are happy to receive the interest payments, others may look for ways to cash in on the bonds before the maturity date, especially if the bond’s value rises. One major factor that will make a bond’s value increase, or decrease, is the presiding interest rate. If interest rates fall below that of a bond, then people will want to buy it for the higher yield.
But, if rates go up, then the bond value drops. The coupon payments may not be great, but you’ll still get the principal back. Unless the underlying entity defaults or goes bankrupt, but even then, in most jurisdictions, bondholders are higher on the creditor queue than other investors.
How to pick the right bonds
Bonds can be a safe haven for any portfolio, but there is still some analysis required before deciding which bonds to invest in. Consulting a trusted adviser like Richard Cayne is always a good idea before putting your money in.