Adding bonds to your portfolio can strengthen the performance of your holdings. It can also minimize the amount of risks your portfolio is facing, while allowing for some regular income coming in your pockets.
Here are the most basic characteristics of bonds you should know about.
A Bond is a Loan
A bond is at its purest a loan a company takes out. Investors lend the business some money when they buy bonds.
The company then pays the investors coupons, or annual interest rate paid on a bond as a percentage of face value. Usually, these coupons are given semiannually. They then return the principal at the maturity date and this ends the loan.
Maturity refers to the date is when the principal or par amount of the bond will be paid to investors. This is also the date when the company’s bond obligation will end.
Secured and Unsecured Bonds
A bond can either be secured or unsecured.
Unsecured bonds are also known as debentures, whose interest payments and return of principal are guaranteed only by the credit of the issuing company. If the company fails, the investor may get little of the investment back.
Meanwhile, a secured bond is a bond in which particular assets are pledged to the holders if the company fails to repay the obligation.
Another key characteristic of bonds is that sometimes they are “callable.”
Some bonds can be paid off by the issuer even before the maturity date. If the bond has a call provision, then it may be paid off at an earlier time at the company’s discretion, often at a slight premium.
Types of Bond Risks
As with many lucrative assets, bonds also carry inherent risks. Here are some of them.
Credit or Default Risks
Credit or default risks refer to the risk that interest and principal payments attached to the obligation will not be paid off.
Interest Rate Risks
Interest rate risks refer to the risk that interest rates will change significantly from what the investor has expected.
If the interest rate falls significantly, then the investor faces the possibility of a prepayment. Meanwhile, if the interest rates increase, the investor will be stuck with an asset that yields below market rates.
Longer time to maturity means higher interest rate risk for the investor. That’s because it’s very difficult to predict market developments far into the future?
Prepayment risk refers to the chance that the bond issue will be paid off earlier than the expected maturity date, usually through callability.
This can be bad news for the investor because the company only has an incentive to repay the obligation early when interest rates have slipped substantially.
Instead of holding a high interest investment, the investors will have to reinvest the funds in a lower interest rate investment.
Bond yields are used to measure the returns gotten from a bond. The yield to maturity if the most commonly used metric for this.
However, there are also other measures such as the current yield, nominal yield, yield to call, and realized yield.