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Finance
What are bonds?
First things first: when you invest in bonds, you are in the business
of lending money. At the most basic level, a bond is simply a loan
which you make to a government or a corporation for a set period
of time. By lending your money to them, the government or cor-
poration can deliver essential services, build infrastructure, fund
corporate growth and expansion into new markets, and so on.
Just like a bank loan, a bond entitles its holder (that’s you, the
investor) to pre-set interest payments for a specified term (this
is called the bond’s “coupon”). At the end of that term, the bond
“matures”and the issuer must repay bondholders the face value of
the bond. This is why bonds are called“fixed-income” investments;
when you buy a bond, you know exactly
howmuch
income you’re
getting,
when
that income will be paid to you, and for
how long.
Why invest in bonds?
Generally, investors have two main reasons for investing in bonds.
The first is stability. While the stock market can fluctuate wildly
over a given year (and, indeed, even over one day), that generally
doesn’t happen with bonds. While stocks generally outperform
bonds over the very long term (i.e. more than 10 years), bonds
are generally much less volatile. This is an exceptionally important
feature for those who need to depend on their portfolios, such as
retirees or anyone saving for short-term investment goals.
The second reason for investing in bonds is the income which
bonds provide. As noted above, bond income is guaranteed and
fixed at the time you purchase the bond. That’s different from
stocks, some of which don’t pay any income at all. Those that do
can sometimes cut back their dividend in times of extreme finan-
cial duress (remember what happened to U.S. bank stocks a few
years ago?). Once again, that certainty of income is an exception-
ally attractive feature for those who live off of their portfolios.
Bond yields
Turn on the TV or read through the financial section and you’ll see
that much of the financial discussion about bonds centres around
a bond’s “yield.”Yield is a simple calculation of the amount of inter-
est which a given bond generates in a year, divided by the bond’s
price. It’s an important measure of the return that the investor will
enjoy if he or she holds the bond to maturity.
So, for example, if you purchase a bond issued by XYZ company
with a coupon of 10% at a face value of $1,000 (this is called buying
“at par”), the bond’s yield will be its interest rate, 10% (100/1000 =
0.10).
But if the bond’s price goes up or down – a fairly common occur-
rence – then the yield will fluctuate as well. Assume that the price
of XYZ’s bond goes down to $800. If you bought at that price, your
yield would be 12.5% – you are getting the same guaranteed $100
on an asset that is worth $800 ($100/$800). Conversely, if the price
of the bond goes up to $1,200, the yield would then shrink to
8.33% ($100/$1,200).
Keep in mind that for most people, yield only matters at the mo-
ment they
buy
a bond; fluctuations in yield are largely academic
once you’ve already purchased. So, for example, if you bought an
XYZ bond for $1,000 and its price goes up to $1,200, you’ll have
a nice $200 capital gain, but your yield will still be 10%. For new
investors, however, the yield on an XYZ bond will be 8.33%.
Bond basics
and beyond
What you need to know about this fundamental asset class
By James Dolan
Many investors hold bonds within their portfolios, but
very few understand the financial workings of this core
investment.
And that’s a shame. Bonds are complex investment
vehicles, with features and benefits that make them
distinctly different from other investments, such as eq-
uities and cash. Getting to know what bonds are (and,
just as important, what they
aren’t
) will help you man-
age your investment portfolio more effectively, both
now and in the future.
With that in mind, here are a few basic things – and
some not-so-basic things – which you need to know
before you invest in bonds.