A bond is essentially a loan, raised by a company or government, and financed by investors. The issuer promises to repay the loan at a future point in time – known as the maturity date. As for the investors (or bondholders), they will receive regular or ‘fixed income’ payments as well as the return of their original stake when the bond reaches maturity. The income an investor receives is called the ‘coupon’. There is no difference between the terms ‘bond’ and ‘fixed income’ – they both refer to the same form of investment.
The different types of bonds
Government bonds
Governments borrow money to raise funds for various, ongoing budget requirements such as infrastructure and defense spending, as well as public pensions. These bonds are widely seen as a relatively low-risk investment, as governments are generally more financially stable than a private company.
Corporate bonds
Companies issue these for numerous funding needs. For example, a firm may need to finance its entry into a new market or to help it to build new premises. While corporate bonds tend to be a less secure investment than government bonds, the risks vary depending on the type of company the investor lends to.
What are the components of a bond’s value?
A bond’s capital value is the price the investor pays for it. Like the shares of a company, bonds depend on prevailing demand-and-supply conditions and the price of a bond can fluctuate in the market.
The coupon rate – also known as the bond ‘yield’ – is the annual coupon payment relative to the bond’s face value. For example, if a bond pays a fixed annual coupon of $6 and the bond’s face value at the date of issue is $100, then the coupon rate is 6%. Of course, the yield will fluctuate as the bond’s actual market value changes.
The yield tends to be higher if the bond’s maturity date is longer. For example, bonds that are due to be paid back in 30 years would be expected to carry a higher yield than those being repaid in two years. Similarly, the yield may reflect the economic environment in which the issuer operates. Therefore, bonds issued by the government of a developing country, for example, Myanmar, would be expected to carry a higher yield than those sold by the authorities in more mature territories, such as Australia or Singapore.
How to invest in bonds?
Directly investing in a company or government’s bonds can be complicated. This is because it requires extensive knowledge and research. Therefore, many people choose to gain exposure to the bond market by investing in a fixed income fund instead.
Fixed income funds are managed by specialist portfolio managers who create a portfolio of investments on the investor’s behalf. They do so by selecting the bonds they think offer the best potential risk-adjusted returns. By constantly adjusting a portfolio to the changing economic climate portfolio managers can also make funds more defensive or opportunistic. Since these funds comprise a high number of different holdings, they also provide diversification benefits from both a capital and income perspective.
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