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Basics of Investing: Bonds

Have you ever forgotten to bring enough money and had to borrow from someone? You must have. All of us have had to borrow money sometime in our lives. And there are usually all kinds of reasons as to why we need to borrow money.

Similarly, companies, and even governments, might need to borrow money from time to time. However, the sums of money that they borrow are very large. So what they do is that they issue bonds.

What are Bonds?

Bonds are basically loans, where you are the lender. The companies or government which borrow the money from you, have to agree not only to pay back the amount they borrowed, but also to pay a little extra in the form of a fee (interest) for the privilege of borrowing your money. These interest payments (coupons) are usually paid at regular intervals (for example, every half a year). The full amount that is loaned out (the principal) is returned back to the lender (you) at a certain date in future. This date is called the maturity date. 

A bond is basically a piece of paper in writing that says that such-and-such company or government borrowed so much money from you. The main difference between stocks and bonds is that the company or government guarantees to pay you back the money you lent, plus interest. You know exactly how much you are going to get back, and when you are going to get it.

Bonds with less than 1 year to maturity are known as money market instruments (there are mutual funds which invest solely in these money market instruments).

Bonds and money market instruments are also known as fixed-income/debt investments. This is because they pay out a regular 'income' (the interest coupons) to investors.

How risky are Bonds?

Although the company whom you lent your money to guarantees to pay you back, it does not mean that bonds are risk-free.

Companies and even governments can, and do go bankrupt. However, when that happens, bondholders will be paid first before paying a single rupee to the shareholders.

But perhaps the most risky thing to bondholders is a rising inflation rate. When the economy is booming and unemployment rates are falling, that is when bonds and bondholders suffer the most (the reverse applies, recessions are great for bonds!). Inflation causes prices of things in general to rise. This means that Rs. 100 in the future would be able to buy less goods and services than Rs. 100 now. So your fixed coupon from bonds would buy you less if there was inflation.

This also means that the money which you get back when your bond matures would be worth a lot less than what it is worth now when you loan it out. So the faster inflation rises, the faster your bond loses value.

Interest Rates

Bank interest rates are another thing bond investors need to watch out for. Rising bank interest rates cause bond prices to fall, and vice versa. This is because bonds pay a fixed coupon. As bank interest rates fall, people are willing to pay more money for the bond because its fixed coupon may represent a higher return than other similar instruments like the fixed deposits. Conversely when bank interest rates rise, people are less willing to hold on to bonds because interest income from fixed deposits would be higher than the fixed coupon of bonds issued in the past, hence leading to a fall in bond prices (or capital depreciation).

Bond mutual funds

If you see bonds as an essential part of your investment portfolio, but yet lack the time or investment capital to buy into local bonds (which can have high initial investment requirements), then opt to invest in a bond mutual fund. Bond mutual funds are basically a collection of different types of bonds. Instead of an individual bond, you are buying into a ready portfolio of bonds.

A lot of people opt for bond mutual funds when they seek to diversify their investments with some fixed-income exposure. Even aggressive investors invest in bonds when the timing calls for it (see Investing in Mutual Funds - Strategies for how this is done).

Next : - Money Markets