Adding bonds to your portfolio helps to strengthen your risk/return profile. It also helps a lot when it comes to calming down the level of volatility you shoulder. However, for beginners, the bond market may be strange and unfamiliar. The following are some of key bond market concepts you should know.
Basic Bond Traits
A bond is a loan taken out by companies where investors lend it money. In exchange, the company pays an interest “coupon,” which is the annual interest rate paid on a bond, expressed as a percentage of the face value, at regular intervals, which can be annually or semi-annually. The company will then return the principal capital at the maturity date, at which point the loan ends.
Some of the most common terminologies you will encounter when investing in bonds are:
Maturity
The maturity of a bond is the date when the principal amount of the bond will be given to the investors. This is also when the company’s obligation will end.
Secured and Unsecured Bonds
Unsecured bonds are also called debentures. Their interest payments and return of capital are guaranteed only by the credit of the company that issued them. Other words, if the company fails, you may get little of your money back.
On the flipside, a secured bond is one where specific assets are pledged to bondholders if the company is unable to meet the obligation.
Liquidation Preference
When a company goes belly up, it pays money back to investors is a specific order as it liquidates. After a company has sold off all of its assets, it starts paying out to investors.
Senior debt is debt paid first, then junior or subordinated debt. The stockholders get whatever is left.
Risks of Bonds
Bonds also come with inherent risks. Here are some of them.
Credit or Default Risks
Credit or default risks are the risk that interest and principal payments due on the obligation will not be met as expected.
Prepayment Risks
Prepayment risks are the risk that a bond issue will be paid earlier than expected, often through a call provision.
This event can be bad news for investors since the company only has incentive to pay the obligation early when interest rates have declined largely. Rather than continuing to hold high-interest investments, investors will have to reinvest the funds in a lower interest rate asset.
Interest Rate Risks
This one refers to the risk that interest rates will change significantly from what the investor expected.
If the interest rates decline significantly, the investor faces the possibility of a prepayment. If, on the other hand, the interest rates increase, the investor is stuck with an asset yielding below market rates.
The greater the time to maturity, the greater the interest rate risk an investor bears. This is because it’s more difficult to predict market developments out into the future.
Overall, although bonds appear complex, the market is driven by the same risk-return tradeoffs as those in the stock market. After an investor masters the basic concepts and terms, he or she can become a competent bond investor.
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