Who Invests In Bonds

WHO INVESTS IN BONDS

Today we are going to look at the following two areas: Who are the people or institutions that usually invest in bonds; (and) What are their reasons for doing so?

First, however, we’ll do a quick recap of some of the basic facts about bonds. A bond is a form of I Owe You (IOU) or loan contract between an issuer (borrower) and a purchaser (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 ... or the redemption date ... on which the principal or face value of the bond will be repaid. Here’s a practical example of how all this comes together: In September 2000, the Government of Jamaica (GOJ) issued a US dollar denominated eurobond that is traded on the international capital market, as are the eurobonds issued by many other sovereign nations. The prospectus attached to that GOJ bond said that the instrument had a coupon or interest rate of 12.75%, payable twice per year on 1st September and 1st March... and that this interest would be tax-free to Jamaican investors. The principal of the bond is to be repaid on 1st September 2007.

Who Invests in Bonds

Investors who are looking for 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. For example, it is possible to purchase GOJ bonds with as little as US$5,000 -$10,000 and the returns may not differ significantly from an investor with US$500,000 at his disposal. The fact that the GOJ eurobonds are denominated in US dollars, and that a number of the issues are tax-free, also make them very attractive to the medium to long-term investor. 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 it is 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 margin and reserve 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 that they can be traded or sold by the original investors, as well as by those who buy them on the secondary market. Bonds tend to be medium to long term in tenor - that is, they tend to have maturity dates that vary from 2 to 30 or more years. This means that without a secondary market or the ability to sell the bonds, the original investors would have to wait until the bonds mature to recover their principal. However, with an active secondary market for the bonds, investors have the ability to sell the bonds long before maturity and to buy and hold the bonds for as long as it suits their particular investment objectives and needs. It also allows them the opportunity to encash or liquidate their investments if emergencies arise that require them to have cash on hand. Longer term investments usually carry a higher interest rate and the ability to sell these bonds before maturity allows shorter term investors to get a higher return on their savings by buying and selling these bonds long before they mature.

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.

Originally published in February 2003

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