What is A Bond?
A bond is a debt security from an organization, either private corporation or government to get money from public. The organization who issues the bond is known as “Bond Issuer”. Every bond is a predefined “matures” or due date. All creditors lend out their money to their borrowers and in return they will charge them interest. Similar process apply to a bond, when you purchase a bond, you are lending money the bond issuer, you are the lender; and in return, the bond issuer will promises to pay you a specified rate of interest during the life of the bond plus the face value / the principal of the bond when it “matures,” or comes due.
Among the types of bonds you can choose from are: U.S. government securities, municipal bonds, corporate bonds, mortgage and asset—backed securities, federal agency securities and foreign government bonds.
Key Bond Investment Considerations
There are a number of key variables to look at when investing in bonds: the bond’s maturity, redemption features, credit quality, interest rate, price, yield and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your financial objectives.
- Interest Rate
Most bonds carry an interest rate that stays fixed until the maturity and it is counted based on a percentage of the face value, for example if you purchase $5000 bond with 10% interest rate, you will be paid $500 a year. The interest payment can be in 6-monthly or yearly basis. You will continue to receive interest payment until the bond is matured, you will get back the full face amount of the bond when in come due, it this case the $5000.
Although most bonds pay the interest in fixed rate, there are bonds with interest rate that is adjustable; the interest rate is reset periodically in line with changes in a base interest.
Some bonds have no periodic interest payments. Instead, the investor receives one payment—at maturity—that is equal to the purchase price (principal) plus the total interest earned, compounded semiannually at the (original) interest rate. . For example, a bond with a face amount of $20,000 maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, the investor will receive $20,000.
- Maturity
A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Bond maturities generally range from one day up to 30 years. In some cases, bonds have been issued for terms of up to 100 years. Maturity ranges are often categorized as follows:
- Short—term notes: maturities of up to five years;
- Intermediate notes/bonds: maturities of five to 12 years;
- Long—term bonds: maturities of 12 or more years.
- Credit Quality
Bond choices range from the highest credit quality U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government, to bonds that are below investment. Since a bond may not be redeemed, or reach maturity, for years—even decades—credit quality is another important consideration when you’re evaluating a fixed—income investment.
- Credit Ratings
The bond issuers are reviewed with their financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond, and they will be rated accordingly either in AAA (the best), AAB, AA, BBB, BB to the worst of D.
Bonds rated in the BBB category or higher are considered investment—grade; securities with ratings in the BB category and below are considered “high yield,” or below investment—grade.
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- Price
The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
- Yield
Yield is the return you actually earn on the bond—based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call. Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought at $1,000 and the interest rate is 8% ($80), the current yield is 8% ($80 ÷ $1,000). If you bought at $900 and the interest rate is 8% ($80), the current yield is 8.89% ($80 ÷ $900).
- Assessing Risk
Virtually all investments have some degree of risk. When investing in bonds, it’s important to remember that an investment’s return is linked to its risk. The higher the return, the higher the risk. Conversely, relatively safe investments offer relatively lower returns.
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