What Are Bonds?
A bond is an IOU in which you, the investor, agree to loan money to a company or government or other known entity - called the Issuer - in exchange for a specified rate of interest over a fixed period of time. Its opposite is a stock, which represents ownership in an entity and is worth only what someone else is willing to pay for it.
A bond is a loan contract between an issuer (borrower) and a purchaser (investor/lender) and, like any loan, it carries a set rate of interest, called the coupon, as well as the dates on which interest is to be paid. The bond contract - which is usually set out in a prospectus - also details how and when the principal or face value of the bond will be repaid (the maturity or the call date).
Here’s a practical example of how all this comes together: In February 2016, Apple Inc. issued a US dollar denominated bond that paid investors 2.85% per year (payable twice per year in August ad February). Apple will repay all investors (in this bond) their principal on February 23, 2023. Essentially – you are lending money to Apple to either help finance the company’s growth, refinance its existing debt or simply maintain its operations. Apple is broadly considered a lower risk issuer (due to its strong growth, high cash balances and low debt burden). For that reason – the coupon on the bond seems low – but is in line with other companies of a similar risk profile.
Another example – the TransJamaican Highway company issued a bond in February 2020. The bond pays interest at a rate of 5.75% per year on a quarterly basis. The company will repay investors their principal in October 10, 2036. This bond allowed TransJamaica to repay old debt at a lower interest rate. The risk profile of this bond is higher due to the company’s high debt burden, low growth prospects and weak profitability track record. For this reasons – investors command a higher rate of interest to compensate for the added risk.
Who Invests in Bonds
Investors who are looking for income and also higher returns on their fixed income investments will find bonds very attractive as they can offer better rates than those that are available in savings accounts or in the money market. Small investors can also participate in these instruments and earn returns that are normally only available to institutional or individual investors with large sums at their disposal. Even investors with a high risk tolerance and preference for equity investments would be well advised to consider putting some of their investments in bonds - even if its just for the purpose of risk reduction, through diversification
Why Invest In Bonds
Bonds offer advantages to both the issuer/borrower and the purchaser/lender. The issuer is able to borrow at a lower interest rate because he avoids the onerous requirements of a commercial bank or formal lending institution. The purchaser also gets a higher interest rate because he is lending directly to the borrower and therefore avoids the costs of a formal intermediary.
Another advantage of investing in Bonds - especially those issued by large companies, governments and government agencies – is liquidity and capital gains. Bonds can be traded or sold by the original investors, just like stocks. Investors have the ability to sell the bonds long before maturity and can own the bonds for as long as it suits their particular investment objectives and needs. It also allows investors the opportunity to encash or liquidate their investments if emergencies arise that require them to have cash on hand.
It must also be noted, however, that while the investor or purchaser of the bond gets a much higher return than he would in (say) a savings account at a bank, he also takes on more risk. Next week’s article will look at some of the risks associated with investing in bonds and how investors can take these into account in making their investments.