A bond is a form of debt and allows companies to raise money from the general public instead of going to the banks. The companies in return pay an agreed interest rate to the investor of the bond.
Why invest in bonds?
Generally a bond returns a regular, guaranteed income for the term of the loan. This is why a bond is called ‘fixed income’, so you can plan with certainty your future income.
At the end of the loan term, the bond returns the full invested capital which is then able to be reinvested.
The returns from bonds are much more stable and regular than shares or dividends. The returns are also higher than the keeping your money in cash.
Bonds are also considered a safer and stable investment than stocks and have much less risk involved.
Key differences between bonds and shares
- Have a Fixed term of interest and repayment.
- They have a specified rate of return. A predefined amount at specific intervals to receive the interest payments for the term of the investment and capital repayment at the end of the live to the bond.
- Bonds show their true value during periods of market volatility and uncertainty. Fixed interest also should make up a major component of any diversified portfolio to reduce risk.
- In the event of insolvency, bondholders are ahead of shareholders and much better protected and much more likely to get their money back.
- There is no fixed term of investment.
- There is no promise or requirement to pay income through dividends or schedule of dividend payments. Any payments are strongly dependent on the performance of the company and is at the discretion of the company directors.
- The share price can fluctuate strongly up and down as we have seen during the GFC. There is no expiry date and shares need to be sold in the market to get the money back. This may realise a gain or a loss on the initial investment.
- In the event of insolvency, shareholders rank behind all other claims.
Major Parts of a bond
Face Value: This is the amount the bond will return at the end of the term.
Purchase price: This is what the bond is purchased for. This might be more or less than the face value.
Coupon: This is the interest rate paid on the bond. This is shown as an annual percentage on the face value.
Yield to Maturity: Often just called the yield, it measures the actual rate of return on the bond. This takes into the coupon rate, and the purchase price of the bond.
Maturity: This is the date on which the initial capital is repaid.
Different Types of bonds
Bonds are available in a few different ways. The two main ones are Fixed and Floating rate.
Fixed rate bonds pay investors a fixed interest rate that does not change over the life of the bond.
Floating rate bonds pay a variable interest rate based off some reference plus a fixed margin. The benchmark rates are periodically adjusted and as such the interest payment you receive may change.
There’s more to learn, like the major factors that impact a bond price, why you might want to purchase a premium bond, or skip a discounted bond, how the yield curve impacts your portfolio, just to name a few.
If you want to learn more, we’ve put together a more detailed write up here.