What is a Bond?
A bond is a debt security that obliges the issuer to pay a certain amount plus interest at a certain date in exchange for the use of the bondholder’s funds. In other words, a government or an entity borrows money for their own purposes and agrees to pay it back at a specified date, offering investors the opportunity to earn a percentage of the security’s par value. The bond’s par value is the amount that the borrower undertakes to pay upon redemption.
What are the Types of Bonds?
Before investing in bonds, it is highly recommended that you understand their classification. In this article, we want to highlight the principal criteria used to categorize bonds.
- Short-term (up to one year)
- Medium-term (up to five years)
- Long-term (up to 30 years)
Method of generating income:
- Fixed-rate bonds
- Floating-rate bonds (coupon is linked to a reference rate of interest)
- Index-linked bonds (both par value and the coupon are linked to a reference rate of interest)
- Government bonds
- Municipal bonds (issued by local government authorities)
- Government agencies bonds
- Corporate bonds (securities issued by commercial organizations)
- Foreign bonds (issued by foreign issuers)
Degree of security:
- Unsecured bonds
- Secured bonds (pledge, collateral, bank guarantee)
- Nonconvertible bonds
- Convertible bonds (at the owner’s request bonds can be converted into shares of the same issuer
Bonds vs. Stocks
The basic difference is that when you buy shares you become a co-owner of the company, and when you buy bonds, you acquire the company’s debt. In other words, you loan the company money. The bondholder is guaranteed to receive income in the form of a coupon (with the exception of the issuer’s bankruptcy), but there is no guarantee that the shareholder will receive dividends from the company; he can only rely on the increase in the shares’ value.
Bonds vs. Certificates of Deposit
In terms of how easy it is to make an investment, the bank’s certificate of deposit (CD) does not require any additional actions after the funds are deposited. You receive regular payments and the risk is very low because CDs are protected by the state up to a certain amount. If an investor wants to buy bonds, he has to open a brokerage account. However, bonds can offer a number of advantages over CDs:
- Low threshold (the par value of most corporate bonds is 1000 rubles)
- Accumulated coupon yield (when a bond is sold, the investor receives the promised profit, but in case of early CD withdrawal the client loses their income for the reporting period)
- Liquidity of the invested capital
- Opportunity to diversify your savings by buying bonds of different issuers
- Duration of investments (if an investor buys long-term bonds, his profit during the entire term of the bond will remain unchanged, in addition, the coupon payment and par value can be indexed to the inflation rate)
- The main advantage is the level of profitability (for both foreign and domestic bonds the level of expected profitability will always be higher than the CD’s)
What to Pay Attention to When Choosing Bonds
- The currency of the expected income, as there are bonds denominated both in rubles and in foreign currencies
- The coupon yield percentage. The higher the percentage, the higher the risks. Always chose securities based on your individual risk tolerance.
- Liquidity. It is important to be able to buy/sell a bond at any desired time.
- Term to maturity. The longer the bond’s term is, the more volatile it is on the market. Remember that the issuer undertakes to redeem the bond at par only at the time of its maturity. However, during its term, the price may deviate greatly from par.
In conclusion, we would like to note that bonds are an easy-to-understand, convenient and reliable tool for all investors, but they must a part of an investment portfolio that is well-diversified By purchasing foreign currency debt securities you get protection against both inflation and foreign exchange risks. Also, the income from bonds can be subject to certain tax exemptions. When building a portfolio of debt instruments, the investor can independently determine his profitability, risks, and maturity dates, which allows customizing the portfolio to the individual needs of its owner.