Many of us have borrowed money at some point in our lives. Large organizations and even governments need to borrow money too. But the amount they require may be much more than a commercial bank can provide. That is why they issue bonds in order to raise money to finance certain projects. Bonds are issued to the public market whereby thousands of people are given an opportunity to raise a portion of the amount required and get it back with an interest.
The organization or government that issues or sells the bonds is known as the issuer whereas the people who contribute to the required capital are the investors. Issuers will pay the investors the money back together with extra cash in the form of interest payments known as coupons. There is a maturity date that is set on which the issuer has to pay back the entire borrowed amount. Interest is usually paid to the investors twice annually, but this will depend on the terms of the bond. The investor will receive the interest every year together with part of the borrowed amount.
It’s very important to understand the difference between debt and equity when it comes to bonds. Bonds are a form of debt and not equity. A good example of equity is when you invest in stocks. Investing in stocks of a given company would mean that you are becoming a part of the ownership of that organization. That is, you are becoming a shareholder. But the same doesn’t apply when it comes to bonds.
Bonds are just a form of debt that will be repaid at a predetermined date. You are just considered as a creditor by the organization or government in which you contributed capital towards its projects. You do not become an owner in the corporation. This means that you don’t have any voting rights or the rights to share future profits as shareholders do.
Nevertheless, bonds are considered a very reliable form of investing. In fact if the issuer becomes bankrupt, there’s a high chance that the creditors or investors will be paid first compared to shareholders who may end up unpaid. As a bondholder, you do not share in the profits of the company. You are only entitled to the principal amount you invested together with the interest. In general, there’s less risk involved in owning bonds compared to buying stocks and becoming part of ownership in a corporation.
We explained in the main article – What are Bonds? – what a bond actually is. A corporate bond is the same thing, except it is just for corporations.
If you haven’t read our main article on bonds yet – we will give you a brief outline here -An organization may require a high amount of capital that a commercial bank may not be able to provide. The organization may then decide to issue a corporate bond in order to raise the required funds. These corporate bonds are mainly used to raise funds to support an organization’s ongoing projects, buy new equipment, invest in research and development, buy back their own stock, pay back shareholder dividends, refinance debt or even expand. They are long-term debts that have a set maturity date. Individuals and companies may invest their money by purchasing the corporate bonds issued by an organization that is sourcing for capital.
Bonds can have different maturity dates. They can have a short-term maturity of less than three years or a long term of more than 10 years. Longer term bonds are the ones that have the highest interest rates, but they also present a higher level of risk. Some corporate bonds will offer a fixed rate of interest or a fixed coupon rate whereas others will have floating rates which simply means that the rate is reset periodically, usually every 6 months. A bond index is used to determine the floating rate.
There are also zero coupon bonds that do not give any interest payments until they reach the maturity date. The investor will only receive a single payment at maturity which includes the interest that has accrued over the years. Investors must pay taxes annually in order to receive interest at the maturity date.
Like all the other forms of investment, there’s always some risk involved when it comes to corporate bonds. The company may fail to make timely payments of interest or even the principal. But when a company defaults, it compromises its credit worthiness. This basically means that it is deemed unable to pay its obligations on time and thus bondholders will suffer.
But what happens if a company goes bankrupt? The bondholders can get their money back using the company’s assets and cash flows. The bondholders will be given priority based on the type of bond that they bought. Those who had invested in secured bonds will have a legal right to obtain their funds back using the company assets such as property, equipment and other things that the organization owns.
Corporate bonds are usually set at different prices but their prices are heavily influenced by the market rates. When the market interest rates increase, the price of bonds usually decreases
Every bond has 3 elements: a coupon, maturity date and principal. The principal is the amount that the bond will give back after a certain period of time known as the maturity date. There is also an interest that will be paid on the borrowed money known as the coupon. Junk bonds also have these 3 elements and are similar to regular bonds but present higher risks.
Junk bonds are usually sold by companies that have low credit ratings. These corporations cannot acquire capital at a cheaper rate and that’s why they turn to individuals to provide them with the needed funds in the form of bonds. Most junk bonds are rated BB or lower by rating agencies like Standard & Poor. So putting your money in a junk bond is certainly a huge risk.
It’s very important to verify a company’s bond rating before you decide to make an investment. Think of this bond rating as the organization’s credit rating. Companies that have proven to perform well in terms of repaying debt have a high rating. On the other hand, junk bonds are sold by risky companies that are yet to prove their credit worthiness.
You may be tempted to invest in junk bonds because many of them pay high yields. However, they carry extreme risk because there’s a high chance that the company will default on the bond. But there are also different categories of junk bonds.
Different Categories of Junk Bonds
The first is commonly known as fallen angels, which as the name suggests, represents those companies that once had a high bond rating but have been reduced to junk-bond status because of poor credit quality.
The other category is known as rising stars. These are junk bonds that are sold by companies which have recently received an upgrade of their credit quality by an issuing company. These companies are on their way to becoming great investments.
Buying a junk bond is certainly a risky thing to do but there comes a time when the rewards can justify the risk. Before you choose to buy a junk bond, understand how long you want to commit your money. Also consider the default rate on junk bonds. Also, keep in mind that junk bonds are more or less like equity because they are affected by shifts in the economy. When there are too many defaults, the bonds can have many negative returns.
If you are looking for a suitable addition to your investment portfolio, consider purchasing bonds. Bonds can be a reliable and safe investment that can significantly contribute to the stability of your investment portfolio if invested in, correctly. When stocks are not performing as good as you expected, you can rely on bonds to provide a steady stream of income. Below are some main advantages of investing in bonds.
Diversify your portfolio
One of the main reasons to invest in bonds is because it can help to smooth out the effects of the recession when most stocks are not performing well. By owning bonds, you can be almost guaranteed that you’ll have a certain amount of income in future and look forward to your retirement. You’ll need bonds when equities decline and the economic cycles are not favoring your stocks.
Debt vs. equity
Bonds can be considered as a form of debt whereas stocks represent equity. What this means is that, when you buy bonds, you will be investing in debt which is much safer than buying equity. The reason is that people who buy equity and become shareholders are usually not given priority when a company goes bankrupt compared to debt holders. Debt holders are usually paid before the shareholders if a company goes bankrupt.
Risk-free form of investing
Bonds from the US government are usually considered free of any risks even though they may not yield as high returns as corporate bonds. If you are looking for a certain way to secure your principal investment then you should consider purchasing government bonds. But keep in mind that not all bonds are safe; there are also junk bonds which are considered to be very risky.
Higher interest compared to commercial banks
If you compare the interest rate charged by banks on their savings accounts, you may discover that they are much lower than bonds. In case you have money that you don’t need in the short term then buying bonds would be a suitable form of investing because it’s less risky and you have higher chances of increasing your investment.
Exempt from taxation
In most cases, when you invest in government bonds, the interest that you obtain will be exempt from taxation which means that you will have higher returns compared to other forms of long-term investing. The interest income that is obtained from municipal bonds is usually not subject to federal tax.
Well, all forms of investment have a risk and return. Only a fool would say there is never any risk involved in an investment. When it comes to bonds there’s also the risk that you will lose some or all the money that you invested, but this depends on several factors. Key among them is the type of bond you had invested in.
Risks in Investing in Bonds
Interest rate risk
When interest rates increase, the price of bonds generally reduces. The two share an inverse relationship. This is because when the market interest rates reduce, investors turn to bonds. Bonds become high in demand and that’s why their prices increase. When the prevailing market interest rates increase, investors will want to sell their bonds to acquire the ones that have a greater return which means that the existing bond will be sold at a much lower price.
A company’s credit rating
There are agencies that rate companies based on their ability to repay debts. When a company defaults in the sense that, it fails to repay the principal and interest according to the agreed timelines, its credit ratings will be lowered. This may really affect the investors because a low credit rating could mean that the company will pay more for future loans. The high-interest rates on loans given to the company can impact on its ability to satisfy its bond holders and that’s where the risk comes in.
Government bonds usually have a huge market of buyers and sellers but it’s a different story when it comes to corporate bonds. Some bonds are not very popular and hence may be hard for an investor to sell. If the bond has very low interest then the bond holder may not get a good return upon sale. The bond holder may even be forced to accept a much lower price than expected when selling the bond because the market is thin.
When buying a bond, you are not always guaranteed that you will get the money back. It all depends on the company’s ability to repay that debt. As an investor, there’s always the risk of default which means that the company may be unable to repay a debt and you end up losing all your money. To ensure you make a safe investment, it’s important to know the company’s coverage ratio before investing. This is basically an analysis of the company’s income and cash flow statements to determine its ability to service its debts in the long term.