7 Things You Should Know Before You Invest in Bonds

Investors are often advised to include bonds in their portfolios, in both good and bad times. Thinking about investing in bonds yourself? Here are 7 things you should know before you begin.

1. What is a bond?

When you buy a bond, you essentially loan money to the entity offering it. The offeror receives your money and promises to pay you back the face value of the bond on the maturity date. The bond is the security backing that transaction.

Various types of bonds exist, from government to corporate and with varying maturity periods.

2. How do bonds work?

Bonds pay a coupon at regular intervals, and pay the face value of the bond upon maturity. The face value and coupon rate remain unchanged from the date of issuance, which makes income from bonds regular, stable, and reliable.

3. How are bonds traded?

Bonds may be bought and sold in the secondary market after they are issued. This means that in addition to their face values, they also have market prices. For example, if a bond is bought at a price lower than its face value, the bondholder will receive coupon payments periodically and eventually be paid with the face value at maturity.

This gives the said bondholder a higher Yield-to-Maturity as compared to someone who bought it at issuance.

4. Bonds are relatively safe...

Bonds are generally, but not exclusively, low-risk as compared to other securities such as stocks and derivatives.

If a company offering bonds goes bust, their assets, when liquidated, will go towards servicing debts and paying bondholders like you before they go towards paying equity holders such as stockholders.

This makes bonds safer investments than other instruments. However, it also means that the returns expected from bonds are comparatively lower than those other instruments.

5. Bonds are not risk-free!

A bond is only as reliable as the entity offering it. If a company is known for paying late or even defaulting on their payments, investors may sell or avoid buying their bonds because they are not confident of getting back their money.

Bonds traded in the secondary market also fluctuate in market price. For example, when market interest rate increases, newer bonds will appear on the market with higher coupon rates. Investors will be less willing to buy older bonds that pay lower coupon rates thus leading to a decrease in their market prices.

6. Bonds can diversify your portfolio

Having a mix of equities and bonds in your portfolio allows you to explore opportunities for capital gains while collecting stock dividends and regular bond coupon payments. This can make up for capital losses caused by market corrections.

Seeing fewer dramatic shifts in your portfolio value will also help you sleep easier at night while holding onto your investments.

7. Match your selections to your financial goals and risk tolerance!

Including bonds in your portfolio can help to achieve your financial goals. But first, consider whether the bonds of your choice will provide the returns you want.

Secondly, assess whether you have the capacity to hold the bond till maturity to see your projected returns, and whether you are willing to risk your money on it.

It is always about finding a good balance between risk and reward before you invest!

 

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