What is a bond?

A bond is basically a debt security, that defines the terms of debt between the borrower and lender. In most cases, the terms of such security are about paying back the principal amount at maturity by the lender. And, interest payments when bonds are held till maturity. Usually, interest payments are made twice a year.

Bonds are issued by a government or corporation. The reasons for issuing bonds for both are different. When a government chooses to issue bonds, in most cases it is about financing its budget deficit. On the other hand, when a corporation issues a bond it’s about financing investments.

When the government or corporation issues a bond, they promise to repay the principal (also, face value or par value of the bond) at a fixed maturity date. And, in between the lender gets regular interest payments.

Now, one is right to ask why do investor choose bonds as a form of investment. The best answer we can think of right now is diversification. Different securities perform differently. Like when it comes to stocks the returns are pretty unpredictable. Some investors diversify to minimize associated risks.

Bonds offer a steady stream of income in form of interest payments. As already covered, in most cases, it happens twice a year.

Can bonds be traded?

Not only that, bonds can also be purchased and sold in the secondary market. But, one thing is for sure, if you are holding a bond then your interest payments and the face value of the bond held till maturity won’t change despite the change in your bond price in the secondary market. So, you can hold it till maturity and you continue to receive payments till your bond matures as per the initial terms.

But, that can also discourage investors to hold bonds till maturity. You may find attractive prices later. One of the reasons could be the rising interest rate environment. When interest rate rises, investors prefer to buy newly issued bonds. So, an older bond that carries a lower interest rate could be sold for lesser.

The same goes for rising inflation environment. With the way things have shaped up in the last couple of years, one is right to think that inflation and interest rates go hand-in-hand. But, that is not always the case. The US Federal Reserve acts when the inflation reading goes beyond a threshold. So, holding bonds that offer fixed interest rates in a rising inflation environment affects investors.

It is worth mentioning here that, bonds different in maturities. The maturity of a bond can range between a couple of months to 30 years or more.

An example?

Before we wind up, let’s understand how this works with the help of an example.

A bond was offered to us for $1,000 that would pay $30 every six months for 20 years. At the end of the 20th year, we would get our investment value i.e. $1,000.

So, the face value of the above-mentioned bond is $1,000. Coupon Payment: $60. Bond’s maturity period: 20 years.

Lastly, and this is important, bonds do carry default risks. When governments and corporations can’t pay interest payments or the investment value of bonds at maturity then, they are said to have defaulted. Though government defaults are a rarity. But, some not-so-well-run corporations can default on their payments. So, even when it comes to investing in bonds one should understand the risks. And, should ensure that they invest only in well-run corporations. For the government, one shouldn’t ignore their Sovereign Credit rating.

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