A bond is a debt security issued by a corporation or government (the “issuer”). When an investor purchases a bond, he is effectively lending money to the issuer for a defined period. During the life of the bond, the investor will receive interest in the form of coupons, while the principal amount will be repaid at the bond’s maturity. Bonds are also known as fixed income instruments because most of them pay interest on a regular basis.
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Bonds are a different asset class to equities. Bonds have a defined lifespan period, from its issuance till its maturity. During the life of a bond, its price may fluctuate while it is traded on the secondary market. However, if bondholders hold a bond until maturity, they are guaranteed to receive the principal of the bond, barring the risk of default. Investing in bonds can help preserve investors’ capital, while receiving coupon payments periodically.
Bonds provide investors with “fixed” income. On a set schedule, bond issuers pay bondholders a predetermined amount of interest payment (also known as “coupon”), which is a steady and predictable cash flow to investors.
Bonds offer diversification benefits to an investor’s portfolio. Government bonds from developed nations are often regarded as a safe haven, providing a favored alternative when equity markets are volatile, while corporate bonds generally provide higher returns compared to sovereign bonds of the same country of origin. A diversified bond portfolio which comprises of corporate and government bonds could provide investors a better risk-adjusted return than a portfolio with only one bond class or one asset class (e.g. equities).
Bonds can play a role as a portfolio stabilizer particularly during the market downturns. During the past stock market crashes, bonds were able to deliver excellent resilience, thanks to its steady and predictable cash flows which help soften the fluctuations of bond prices. Therefore, combining bonds and stocks can help enhance the resilience and risk-adjusted returns of your portfolio.
Key Features of Bonds
Like all loans, bonds also have a set time for repayment of the loan principal. The maturity date of a bond determines when the bondholder will be repaid the loan principal.
The loan principal is also known as par value, face value or nominal value of the bond. When a bond is issued and traded on the secondary market, the price of the bond can fluctuate. Regardless of the price you pay for the bond, you will receive the par value upon maturity.
Coupon is the periodic interest payment made to bondholders during the life of the bond. It is expressed as a percentage of par value. For fixed rate bonds, coupon amount does not change for the entire life of the bond.
What to expect when investing in Bonds?
There are two components when investing in bonds: income return and capital return (appreciation/depreciation).
Total Returns = Income Return + Capital Return
Income return refers to the coupons that a bondholder receives.
Capital return refers to the gain (appreciation) or loss (depreciation) on the bond from the fluctuation of its price as market interest rates change, for example:
An investor holding $1,000 worth of bonds that pays 5% per annum will receive $50 every year till maturity, as income.
Capital return refers to the gain (appreciation) or loss (depreciation) on the bond from the fluctuation of its price as market interest rates change.
If an investor buys a bond at $900 and subsequently sells it for $850, he would incur a $50 capital loss. However, he may also choose to hold it to maturity and receive the par value of $1000 which gives him a capital gain or appreciation of $100 (on assumption company does not default).
Total return of a bond is the sum of income return and capital return. This is similar to stocks investments where total returns are the summation of dividends received and capital appreciation/depreciation when sold. The most important difference, however, is that in shares investments, you are not certain of both the dividends and capital appreciation/depreciation components when you sell the shares. For a bond, you know the coupon amount that will be paid every year. You will also know the capital appreciation/depreciation that you receive if you hold the bond to maturity by comparing the difference between the price you paid for the bond and its par value. This return information for a bond can also be derived from its yield to maturity.
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