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How do bonds work?

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Most financial markets allow you to invest and trade in a wide range of financial instruments. While most people usually invest in stocks, you can invest in exchange-traded funds (ETFs) and bonds as well! Diversifying is also a great well to make a more balanced portfolio. However, these options may be a little more complex and opaque to most beginner investors. Most investors do not tend to invest in bonds because they get confused by what it is, and the terminology surrounding it. However, simply put, they are just debt instruments. In this article, we attempt to explain what a bond is, and how they work. If you are interested and are looking to start investing in bonds, be sure to work with a reputable broker such as Saxo Markets before making your investments.

What is a bond

Simply put, a bond is a type of loan. An investor will give this bond to a borrower. The borrower (such as the government or a company) will then use the money from the bond to fund its operations, whilst the investor receives some interest on the investment.This interest (otherwise known as a coupon) is generally paid at predetermined intervals, often annually or semi-annually. When the lifespan of a bond is near completion, the borrower will return the principal (the final amount paid back), thereby ending the loan. In a way, you can say that a bond is similar to an “I Owe You” loan between an investor and a borrower.

Bonds tend to be negotiable securities, which means they can be bought and sold like stocks. Again, similar to stocks, they are also subjected to the market forces of supply and demand. This means that a bond’s value is highly dependent upon its interest rates. Therefore, when interest rates rise, bonds are less attractive. Vice versa, when interest rates drop, bonds become a more attractive option.

However, bonds are still slightly different that stocks. Although plenty of bonds are listed on exchanges such as the London Stock Exchange (LSE), they are instead often traded over the counter (OTC) via institutional broker-dealers. Additionally, bonds can also vary depending on the terms of their indenture – the legal document describing their characteristics. Due to each bond issue being different, borrowers must thoroughly understand the various characteristics of bonds before considering them.

Characteristics of Bonds

Here are a few major characteristics of bonds that an investor should know before diving into this world.

Face value

This is the amount that the bond is worth at its maturity (which is when the loan is due in full). This value is also what the bond issuer will use when trying to calculate or determine its interest payments.

Coupon dates

Much like its name suggests, this is the date when the bond issuer will have to make interest payments. This is normally annually or semi-annually.

Coupon rates

People often group coupon rates alongside the coupon date. Essentially, it is the interest rate the bond issuer will have to pay, and it is dependent on the face value of the bond. To calculate it, you divide the annual payments by the bond’s face value.

Maturity date

This is the date when the principal of the bond is paid, and the bond obligation ends. Therefore, the date defines the lifetime of a bond. This is one of the primarycharacteristics an investor should consider when it comes to their investment goals. A bond’s maturity is typically classified in one of three ways:

  • Short-term: These bonds tend to mature within one to three years.
  • Medium-term: These bonds tend to mature around over ten years.
  • Long-term: These bonds have the longest maturity date.

Secured/Unsecured

A secured bond means it pledges certain assets to a bondholder if it cannot pay back the loan. As such, if the bond issuer defaults, the assets are then given to the investor. An example of this would be mortgage-backed security (MBS), which is backed by the homes of borrowers.

In contrast, unsecured bonds are not backed.So, the interest and principal are the only things guaranteed by the issuer. Therefore, they are much riskier than secured bonds.

Types of bonds

Much like stocks, there is a wide range of bonds available for you to choose from. Most bonds tend to be identified by their issuer – as we can see below. Below are the four major types of bonds people often look for:

Corporate bonds

These bonds are issued by corporations that want to get more funding for their own investments. Most people see bonds from well-established companies as a conservative investment. However, they are still riskier than government bonds and have a higher interest.

By buying a corporate bond, an investor can become a creditor, thereby enjoying more protection from a loss than if you were just a simple shareholder of the company. For instance, if the company is liquidated, the bondholders will be compensated before the shareholders. You can evaluate corporate bonds through rating agencies such as Standard & Poor’s.

Municipal bonds

Local government authorities often use these kinds of bonds. This can include cities, municipalities, councils, or districts. They are often used to finance local infrastructure projects. Much like government bonds, they are considered low-risk and offer low-interest rates. In certain places like the US, municipal bonds may be exempt from certain taxes at either the local, state, or federal levels.

Government bonds

In the UK, government bonds are called gilts. These bonds tend to be pretty popular because bonds from stable and established economies are often regarded as being low risk. Most government bonds have a fixed interest rate, and they also offer types that vary the coupon payment, which is based on inflation. In the UK, these are called Index-linked gilts.

How do they work?

As stated above, a bond works by an issuer paying back a regular amount to the investor. For example, say an entity needs to raise money to finance something. They can then issue a bond and set the price for it. The issuer will then sell the bond to a willing buyer. The bondholder will then loan capital to the issuer, who will then repay back the loan as outlined by the bond’s condition. This is done through a series of fixed-interest payments regularly. The principal amount is paid last when the bond finally reaches maturity or expiration.

Refs:

https://www.investopedia.com/articles/bonds/08/bond-market-basics.asp

https://www.nerdwallet.com/article/investing/what-is-a-bond

https://www.entrepreneur.com/money-finance/what-is-a-bond-and-how-do-they-work/438643

https://www.ig.com/en/bonds/what-are-bonds-and-how-do-they-work

https://money.howstuffworks.com/personal-finance/budgeting/bonds.htm

https://www.citibank.co.uk/personal/knowledge-centre-bonds.do

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