Investing in Bonds

My friend left a comment and said that there was a trend in bond investing, therefore I’m blogging specifically about bonds in this post. Bonds are basically fixed income instruments, but it does not mean that there are no risks involved. Basically, you are taking some form of risk even when putting your money in fixed deposits, because even a bank can go bankrupt. Yes, you didn’t see wrongly. Note that just because we rarely see banks go bankrupt does not mean that it can’t happen. Returning to our topic… Bonds is basically a way for companies to borrow money from the public.

Bonds are first issued and then traded on the exchanges. When it’s first issued, the company gets a sum of money in return for the promise to pay either yearly or semi-annually coupon payments. To illustrate this, bonds are normally denominated in $1,000. Therefore, you will invest $1,000 upfront and the company will give you a sum of money every year or every 6 months, ranging from 5% annual interest or more upwards. At the maturity of the bond, the company will also pay the bondholder $1,000 back. To make matters more confusing, sometimes companies offer their bonds at discounted or premium rates, which basically means you can buy the bond for a lower or higher cost.

However, when you invest in bonds, you will notice that they will provide figures like ‘Annualized %yield’, which is ultimately the figure you should be interested in. The higher this figure is, the higher interest you are getting over the period of time. I don’t think you have to know how to calculate the figure, since you will need a financial calculator. What you do need to know is the coupon payment amount, the number of years to maturity and the yield%. The reason you need to take note of the coupon payment amount is to plan your re-investments upon receiving these coupon payments. The number of years is important, since if you do not intend to hold your bonds until maturity, bond prices can be affected by current interest rate prices. Yield% is self explanatory, it’s the interest rate you are getting.

For new bond investors, you should only invest in bonds that fit your investment span. If you’re only going to invest for 2 years, get a bond with around 2 years to maturity, so that your investment will be almost risk-free and unaffected by fluctuations in interest rates. Bond prices are inversely proportionate to interest rates. Therefore, when interest rates are low, bond prices are high and vice versa. The longer the period left to maturity, the higher the percentage change in bond prices when interest rates move. With this two sentences, one thing is clear: Unless you want to play with interest rates or lock into the current interest rate for long-term, don’t buy a long-term bond.

What’s the risk?
The only risk that you do not get back your money considering you hold the bonds to maturity is the event that companies fail to pay you. They are required by law to pay you and if they don’t pay, they can go bankrupt. Therefore, bondholders like conservative companies, since these companies are unlikely to go into bankruptcy. Even if a company goes into bankruptcy, it’s also likely to get some of your money back, since whatever’s left of the company will go to debtors and bondholders first. In your analysis for bonds, you just have to ensure that companies have enough cash flow to service their debts. There’s no need to look at the upside, since you won’t get anything more, if you buy standard bonds. There are instruments like convertible bonds where you can convert your bonds into shares, but we won’t go into them here.

Bond Ratings
There’s more good news: There are rating agencies that give bond ratings like AAA, AA, A, BBB and so on… AAA is the best grade, which means it’s very unlikely to default on its payments. Consequently, their yield% are normally the lowest as well. The specifics of how they derive the bond ratings are left to the individual rating agencies, but they are normally looking at whether the company is likely to weather through all economies. Blue chips (large companies) normally enjoy good bond ratings. Below a certain rating, bonds are termed as junk bonds, but that does not mean that they are useless. These bonds provide higher returns for higher risks and it’s up to the individual to decide.

I have typed a really long post over here and I think I got to stop. It’s not very comprehensive, but investing of any kind is no child’s game and cannot be covered in just a blog post. However, I believe that I can continue to offer good information to my visitors and if you have any clarifications, feel free to ask. Even my friend who has traded very successfully has confessed that he does not know much about bonds, so what’s stopping you from asking? I may not know all the answers to your questions, but that’s where I will grow also. I will dig up information or maybe other visitors will comment and the result is that we all learn. Let’s move forward to a life of financial freedom.