Bonds may be perceived as safer investments compared to alternative financial instruments, like stocks. Although returns are generally stable, one should give weight to other variables such as risks specific to bonds.
What are bonds, really?
Bonds are a type of financial instrument issued by corporations or the government through which the investor lends a specified amount of funds to the issuer. This means that when you buy a bond, you’re lending money to a company, or the government. In return, the other party promises two things: to pay interest and the repayment of your original investment when the bond matures.
But not all bonds are created equal. The type of bond that you invest in has an impact on the level of cover or protection that you get, in the unfortunate event that the issuer defaults. This is what differentiates secured, from unsecured, and even, guaranteed bonds. Secured bonds are backed by assets, increasing the chance of repayment. Unsecured bonds are the least safe as no assets back them up. Guaranteed bonds imply that a third party guarantees to cover the original investment.
Three benefits of investing in bonds
- Steady Income. Bonds usually pay interest at fixed intervals.
- A balanced portfolio. By including different types of securities in your investment portfolio, you diversify and spread your risk.
- Low Risk: Generally, bonds are considered less risky than stocks (but they are never risk-free).
Three risks you should be aware of
- Fluctuations in Interest Rates. Between the acquisition date and the maturity date, a bond’s price (market value) can fluctuate according to interest rate changes. Specifically, if interest rates rise, bond prices fall, and vice versa. This is crucial for investors to know, especially if planning to sell their bonds before maturity.
- Credit Risk. Sometimes, the borrower might encounter difficulties in fully paying you back. Beware, higher interest rates often mean a higher risk.
- Inflation. If inflation outpaces your bonds’ interest rate, your returns can be eroded.
Commonly asked questions
Are my payments guaranteed?
There is no full guarantee that either interest payments will be made, or that the principal repayment is guaranteed. However generally speaking, some bonds, like secured bonds, are safer than others (e.g. unsecured bonds).
How can I tell which bonds are riskier?
Generally, the higher the interest rates, the higher the risk.
Some bonds are rated by agencies (often referred to as credit rating agencies) to provide an indication of the risk level, however, local bonds often do not have ratings. Hence, it is strongly advised to carefully read the prospectus and to assess the issuer’s financial health before investing in a bond.
What affects bond interest rates?
The interest rate on a bond is influenced by several factors such as the issuer's credit quality, market conditions, economic indicators, and the bond's maturity date.
Three tips for investing like a pro
- Always read the prospectus as this is the bond’s instruction manual.
- Discuss with a financial advisor for personalised advice.
- Understand the risks. Do not solely chase high interest rates – see whether these underlie risks which you may not be comfortable with.