What is a bond?
Bonds are essentially fixed term ‘IOUs’ issued by governments and corporations looking to raise money. When you invest in a bond you are lending the bond issuer money and in return they agree to pay you a fixed rate of interest, known as the coupon, during the life of the bond. When the bond matures, which marks the end of the loan period, the issuer reimburses your capital.
Why invest in bonds?
Bonds, also known as fixed interest securities, have the potential to pay a greater return than cash savings, although they are more risky, and are considered less risky than equites. The return on bonds can be twofold. First is the income received through the coupons. Second is the payment you receive if you sell the bond. Of course, if you hold the bond until it matures, you will get your entire principal back, unless the entity which issues the bond defaults.
But you might be able to get more than your principal back. Bonds can be resold in the secondary market before they mature, which is the end of the loan period. Sometimes bond traders will bid up the price of the bond beyond its nominal value. That would happen if the present value of the coupons and the principal is higher than similar bond investments.
Bonds and Credit Risks
One of the main risks associated with bond investing is the issuer getting into financial trouble. This is known as credit risk, which is the probability that the issuer will not pay the coupons or the principal i.e. the original loan back, on the agreed dates. It’s hard to judge now whether a company is solvable in for example 10-years’ time, which might be the length of a bond contract and that's why credit rating agencies, such as Moody’s or Standards & Poor’s issue credit ratings, which rate issuers’ ability and willingness to pay the coupons and the principal. Credit ratings can be investment grade, which means you are less likely to lose your capital invested on these bonds, or high yield (sometimes referred to as “junk”), which means that it is more likely to lose your capital but in return these bonds also tend to pay a higher rate of interest, or coupon.
Like stocks, bonds can be packaged into a bond mutual fund, where an experienced fund manager will pick and choose bonds to hold on behalf of investors.
Over the long haul, bonds are more risky than cash savings but less so than equities - and hence they tend to have lower returns compared to stocks. However as is the general rule of thumb when it comes to investments – the greater the return on offer, the bigger the risk involved.