How do bonds work?
I've heard that investing in bonds is a solid thing to do, but I'm not really sure what that means.
Answers | 3
1) Credit Risk
2) Interest Rate Risk or Duration
Credit Risk is based on the borrower's ability to service its debt and pay the periodic coupon payment from its cash flows. The higher the debt service coverage that a company has, the lower the risk that it might renege on its periodic interest payments. This risk is also a function of the balance sheet strength of the issuing company in addition to its cash flow generation.
Interest Rate risk depends on whether the interest rates are rising or falling. When interest rates are falling, Bond prices generally rise, as the future cash flows are discounted using lower rates and vice-versa. In a low interest rate environment like we have had this decade, owning Bonds can be very tricky, as rates start to normalize higher, the value of the Bonds declines, creating a capital loss.
Bond owners do not own any equity interest in the business. The above is a very basic description of how Bonds work.
First, what is a bond? It's probably easiest to think of a bond as a loan from the issuer to you. The issuer promises to pay you back on certain term and conditions (the interest rate and times you’ll be paid, and when the balance will be paid back to you).
The good thing about bonds is that the income is fixed, based on the interest rate the bond pays (or a combination of the stated interest rate and the price you paid for the bond if you paid something other than the face value).
The bad thing about bonds is that the income is fixed, as stated above. The current very low interest rate environment clearly illustrates why this can be a bad thing.
So, just how solid a bond is depends on the stated interest rate, any difference in the purchase price from the face value, how long you hold the bond, and the terms under which you sell the bond. Additional factors that can have a significant impact on the market value of a bond are its credit quality (essentially the perceived ability to pay off the bond by the entity issuing the bond) and the duration of the bond (generally, the shorter period of time until the bond is scheduled to be paid off, the lower the risk factor).
One additional factor you may want to consider is diversification. Owning just one or a small number of bonds generally carries a higher degree of risk than owning a broadly diversified portfolio of several bonds (which could provide you with a more “solid” investment).