Are you looking for investment opportunities that do not entail too much risk? Or perhaps are you aiming for the long game with stable investments?
Here’s the magical answer: Bonds.
What are Bonds?
While you hear your friends talking about abc and xyz stocks, how often do you hear people discussing bonds?
Bonds are very simple debt instruments. It is simply a loan taken out by a company. The catch is that instead of going to the bank, the money is raised from investors who purchase these bonds.
In exchange for capital, the company pays an interest coupon, which is the annual interest rate paid on a bond expressed as a percentage of the face value. Essentially, this is the “interest payment” that the company makes, but instead of making them to the bank, they’re made to the bondholders.
At the bond’s maturity (end of agreed period), the company then pays back the principal of the loan.
Bonds are generally considered to be safer than stocks, but it is important to note that the bond ratings (read on to find out more) given play a big role as well.
Due to the lower risks involved in a bond, the returns are usually lower as well… Well, low risks, low returns, am I right?
That’s not to say that bonds are riskless, or that they’re worthless as well. If the bond pays a higher coupon than the interest rate given in your savings account, then it’s definitely worth it right?
Risks of Bonds
Okay jokes aside… Bonds, like any other investments, do have their set of inherent risks as well.
1. Interest Rate Risk
A fluctuation in interest rate may cause the price of bonds to change accordingly. If the bond is locked at the present interest rate of eg. 2%, and in the next year, the interest rate is expected to reach 3%. This would mean that there are new bonds issued tagged to the 3%, causing the price of the bond that you are currently holding to drop.
2. Credit/Default Risk
There is always a risk of the company defaulting on the debt. It is important to do the necessary research on the company before purchasing their bond.
3. Prepayment Risk
This occurs when a given bond issue is paid off earlier than expected. This can be bad news for the bondholders should they be enjoying a higher coupon rate compared to the prevailing interest rate out there.
Most bonds are rated based on their quality of credit, which means their ability to pay the principal and interest. Ratings are publicly published for investors and professionals to judge.
The most popular bond rating agencies include Standard & Poor’s (S&P), Moody’s Investors Service (Moody) and Fitch Ratings. Ratings range from AAA to D, and these ratings are explained in detail by the respective agency.
Bonds that are rated BBB and above are called “investment grade”, which means that they are the ones deemed to be safe and stable.
All in all, bonds are relatively safer as compared to their equity counterparts. However, this does not mean that they do not have any underlying risks! It is always always important to read, read and read (!!!) to find out more about the instrument and the underlying company that you are pouring your money into.