Bond is a fixed income instrument that can help you diversify your portfolio. The bond market is big and diverse and here we will try to make sense of some of the terms that will help you have a deeper knowledge of the bond market.
Characteristics of Bonds
It is the original cost of the loan which you are going to get back when the bond matures. It is usually $1000. Usually bond prices begins to fluctuate once they resume trading on the secondary market. But at maturity, the bond issuer pays the bond holders the face value of the bonds.
The is the day the bonds come due. It is the date the bond investors will get their money and the bond issuer will end all its obligations. A five-year bond matures after two years. A ten years bond matures after ten years. Most bonds mature at least within 30 years of issue. But there are still short-term bonds that mature after just a year or two. Those kinds of bonds are usually called notes.
Bond yield is the amount of return you are going to get for investing in a bond. It is the sum total of the profits you are going to make by the time the bonds matures.
Coupons are the amount of interest paid to bond holders. These interests are usually paid annually or semi-annually. When you invest in a 10-year bond that has an annual coupon payment of 7%. It means that for the next ten years, an interest of seven percent will be paid into your bank account.
If a bond is callable, it means that the issuer can pay back their obligation to the bondholders before the maturity date. A ten-year bond can be called back in six years if it has a call option embedded in it.
Bond Rating and Risks
Credit Rating Agency is a company that evaluates the financial conditions of debt issuers and assigns credit ratings which rate a debtor’s ability to pay back the debts and the likelihood of default.
If a country or a company have a low rating from any of the reputable rating agency, it means that the country or company is likely to default in it’s debt obligation. Even if they succeed in raising funds in the bond market, they have to be willing to pay high coupons on the bonds to attract investors.
But a country or country with high rating like AAA to Aaa will raise funds easily at low coupon rates because they can pay back the debts.
Investing in bonds can be a great investment especially when it comes to preserving one’s capital. But bonds investors are exposed to a lot of risks. Chief of those risks includes:
Interest rate risk
The interest rate risk is the biggest risk that affects the bond market. There is a negative relationship between the prices of bonds and interest rates. That is, the higher the higher the interest rates, the lower the prices of bonds and the lower the interest rates, the higher the prices of bonds.
This happens because if interest rates go down, investors would want to buy bonds that have higher coupons, increasing the demand for bonds and therefore pushing it’s price up. On the other hand, if interest rates go up investors don’t care about what is going on in the bond market. Their indifference naturally pushes the prices of bonds down.
Bond investors also have to deal with inflation risks. Because bonds are fixed income instruments they are affected very much by changes in prices. If you invested a hundred thousand naira in bonds that will mature in ten years at 7% annual coupons. But by the third year since the bonds were issued inflation rose by more than 10%.
If the inflation rates stayed like that for the remainder of the seven years, you most have achieved a negative return because the high inflation has eroded the purchasing power of your money and standard of living have gone up.
When a bond issuer is no longer able to repay its obligation, that is when a default occurs. Before you buy a bond, the default risk in that bond is the likelihood that one day, the issuer will not be able to repay the debt.
Default risk is mostly higher in corporate bonds but investors still take the risks of buying these bonds because of higher coupon rates.