In the financial world, bond is one of the most common investments made by investors. The ‘bond’ mentioned here is different from the one you have seen on the big screen played by Daniel Craig although they all served as a last name. Government bonds, treasury bonds, and corporate bonds just to name a few. You might even come across the term “bond investing” when you flipped through financial news or books. However, bond remains a mystery to many investors. By definition, a bond is a debt instrument that an investor lends money to an entity who borrows the funds for a specific period of time at a fixed or variable interest rate. Well, anyone can quote the definition of something without knowing any further details of it. So now, we will explore and look deeper to find out what a bond really is.
“Hi, I’m Bond. James Bond. Oops! Sorry. Wrong ‘bond’. It’s Treasury bond.” [Images from: www.youtube.com & www.wsj.com]
Do you still remember the pizza company that we built together during our discussion on stock? At the initial stage, we gathered a few partners to fund our company and in return we gave them a share of the company. For bonds, we raise capital through debt instead of equity. This means that we issue bond certificates to the investors stating that we will payback their investments plus at maturity date. The whole process looks like a loan just that the fund providers are investors instead of banks. We will then use the additional capital to fund for activities such as expansion or other capital projects. The bonds we issued are known as corporate bonds. There are a few different names for bonds. Their names are based on who is the issuer of the bonds. For example, government bonds are issued by the government and municipal bonds are issued by states and municipalities, and corporate bonds are given by corporations.
You will learn a few new words when it comes to bond investing. The first term is face value. Face value is the amount of being loaned by the investors which represents how much the bond worth at its maturity. Besides that, face value also used to refer as the amount the bond issuer to calculate the interest payments. Interest payments from bonds are known as coupon payments. Coupon payments are calculated based on the coupon rate which is the interest rate that the bond issuer agreed to pay on the face value of the bond. Usually, coupon payments are made semi-annually. Maturity date is the date when the bond matures and the bond issuer will pay the face value of the bond back to the bond holder. The last term is the issue price. Issue price is the original price that the bond issuer first sells the bond.
This is a U.S. Treasury bond certificate with the face value of USD $1000. The top part of the certificate states the coupon rate and the maturity date. [Images from: scripophily.net]
Currently, there are different types of bonds out there in the market. Each has their own features that satisfy different risk appetite of the investors. One of them is the zero-coupon bonds. As stated in their name, zero-coupon bonds do not pay any coupon payments. You might be wondering why anyone would buy such bond because isn’t bonds with coupon payment are far better and far more rewarding? Well, zero-coupon bond issuer will attract investors by selling their bond at a discount and the market price will converge to the face value upon maturity. The second type of bond is convertible bonds. Convertible bonds are bonds with an embedded option where the bond holders have the choice to convert their investments into stock or equity when they think such conversion is attractive and profitable. This type of bond enables bond holders to obtain the equity of the company at a much cheaper price. The third type of bond is callable bonds. The term ‘callable’ means that the bond issuer has the right to call back the bonds from the bond holders if the interest rates drop sufficiently. They will recall the bond and obtain financing from other financial institutions because the interest rate is cheaper. The most common bond issued nowadays by the corporates is bullet bonds. Bullet bonds are also a type of non-callable bonds where the issuer cannot redeem the bond earlier than the maturity date.
After knowing a little more about bonds, a type of fixed-income of securities and one of the three main parts of the assets in our portfolio besides stocks and cash, we as a knowledgeable investor shall find ways to balance our portfolio. This is crucial as it will diversify our overall risk exposure. Diversification is not an easy task but worth the effort. We all have different views and thoughts on the risk appetite and financial goals we have in our mind. Therefore, all of us will have a different target investment mix. Take your time to find the suitable mix and you will be on your way to make your money work harder for your future.
Never risk all your investment in just one type of security! [Image from: www.glasbergen.com]
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Investopedia.com (2003) ‘Bullet bond’, in Available at: http://www.investopedia.com/terms/b/bulletbond.asp (Accessed: 16 October 2016).
Guide to diversification (1998) Available at: https://www.fidelity.com/viewpoints/guide-to-diversification (Accessed: 16 October 2016).
Prepared by Goh Jia Jun.