There’s an increasing interest in investing among the young and more mature individuals. Two of the main choices are bonds and stock investments. The mere mention of these terms raises confusion among many individuals, and rightly so. These two financial instruments can be hard to understand and predict.
Between the two, more investors prefer to dip their hands in stock market investments simply because the stock market is perceived as less complicated and, in some cases, offer extremely high returns if you understand how it behaves.
Bonds, on the other hand, are seen as more stable and less volatile. But it can be fraught with challenges and risks, too.
In this article, we’ll list out the most important things you need to know about bonds and the reasons why you need to get familiar with bonds before investing.
What are bonds?
Bonds are one of the methods employed by a corporation or a government to raise funds by borrowing from interested investors. Unlike stocks, which represent a stake of ownership in a specific company, bonds represent debt. An entity that issues a bond to an investor (or lender) must pay the interest on a regular basis and the principal amount upon maturity.
Each bond has a certain par value attached to it, and issuing entities (or lenders) pay for the interests in the form of a coupon. This means the company or government pays a certain percentage of the principal amount they borrowed on a regular basis, say, once or twice a year until the bond matures.
This means bonds investing could offer safe and stable returns to the lendee (or bonds investor), granting that the lender doesn’t go bankrupt.
Why do you need to understand how a bond works before investing?
The preceding section merely pointed out the basics of bonds. In reality, bonds are complicated and they have accompanying risks. In some instances, you might end up losing everything if you don’t do your homework properly.
Investing in bonds can be risky to novice investors, who are exposed to the threats discussed below.
- Interest rate risk
This is defined as the potential investment losses resulting from fluctuating interest rates. Typically, the values of bonds and other fixed-income investments move against interest rates. This means when interest rates increase, the bond prices decrease.
- Credit default risk
Bond issuers may suffer from cash inflow problems, making them unable to pay investors on time. Worse, if they’re on the cusp of bankruptcy, they may not be able to pay you back the principal amount. When a bond issuer goes bankrupt, its bonds lose all its value.
In some cases, lender-companies can sell their assets to pay back its investors. This does not guarantee that an investor gets all his or her money back, though. When the company files for bankruptcy, a judge will decide how much money the bondholder (or investor) receives, and it’s almost always only a portion of par or face value.
- Prepayment risk
While less worrying than a credit default risk, a prepayment risk doesn’t work in the interest of the investor, either. Prepayment risk refers to the possibility of the lender paying the principal amount earlier than expected, causing the lender/ investor to receive a measly amount of interest payments, which is calculated based on the principal amount borrowed.
- Not knowing how bonds work can cause you to shell out more cash than you should
Some bonds charge hidden costs that are not known to unsuspecting investors who want to buy or sell bonds. Succeeding in bonds investing takes due diligence, and most often, you need the help of a bonds broker to explain the ins and outs of the whole system. In some cases, there are terms that aren’t known to investors upfront, and you’ll be surprised how much money you need to shell out in order to pay for charges just to buy a single bond. Study the different types of bonds first to know which one best suits your financial goals.
- Not knowing how bond yields work may lead to bad investment choices
There are a few ways to predict how much you’re going to get. Understand how returns or bond yields are computed can help you make smarter investment moves.
Bond yields refer to the measurement of returns. They’re typically calculated via yield to maturity, but some forms of measurements are used on some occasions.
Yield to Maturity. This measures the return of the bond if it’s held to maturity and all coupons are reinvested at the same rate. You can use financial calculators or computer programs to compute YTM.
Realized Yield. Defined more as a calculation of an estimated rather than an actual return, a realized yield is the return for bonds that are not held until maturity. It happens when an investor sells the bond before maturity. And because the future bond price is hard to foresee, the computation can’t represent the actual return amount upon selling the bond.
If you decide to sell your bond early, you’ll be subject to liquidity risk. This means you might not be able to find a buyer or fair price for your bond.
Current Yield. This projected return is calculated when comparing the interest income from a bond against a dividend income provided by a stock. To come up with the current yield, divide the bond’s annual coupon (amount) by the bond’s current value.
Nominal Yield. Dividing the annual coupon payment amount by the face value of the bond will give you the nominal yield on a bond. Because the current bond price is usually not the same as the face value of the bond, this is typically used for computing other measures of return.
- Not knowing how bonds work may cause you financial distress.
Investing in a bond means you won’t be able to have access to your cash for a long time. If you think you’ll need money in the next few years, consider investing only in short-term bonds. There may be a possibility to take it out but you’re going to pay for exorbitant penalty fees.
The Bottom Line
There are a variety of options when it comes to investing. That being said, it’s risky to shell out your hard-earned cash on something that cannot guarantee a return on investment. Before making a move, consider your situation, and assess whether you can manage the risks involved in owning different types of bonds.