What aspects do I have to look for if I choose to invest in bonds?
There are a number of key variables to look for when investing in bonds: the bond's maturity, redemption features, credit quality, interest rate, price, yield to maturity and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your investment objectives.
Maturity: A bond's maturity refers to the specific future date on which the investor's principal will be repaid. Bond maturities generally range from one day up to 30 years. Maturity ranges are often categorised as follows:
- Short-term bonds: maturities of up to 4 years
- Medium-term bonds: maturities of 5 to 12 years
- Long-term bonds: maturities of 12 or more years
Redemption Features: While the maturity period is a good guide as to how long the bond will be outstanding, certain bonds have structures that can substantially change the expected life of the investment. For example, some bonds have provisions that allow or require the issuer to repay the investors' *principal at a specified date before maturity. Bonds are commonly "called" when prevailing interest rates have dropped significantly since the time the bonds were issued.
Before you buy a bond, always ask if there is a call provision and, if there is, be sure to obtain the yield to call in addition to the yield to maturity. Bonds with a redemption provision usually have a higher return to compensate for the risk that the bonds might be called before maturity.
Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment return you are seeking within your risk profile. Some investors might choose short-term bonds for their comparative stability and safety, although their investment returns will typically be lower than would be the case with long-term securities. Alternatively, investors seeking greater overall returns might be more interested in long-term securities despite the fact that their value is more vulnerable to interest rate fluctuations and other market risks. Longer term bonds will fluctuate more than short term bonds - even though they might have higher yields to maturity.
Credit Quality: Bond choices range from the highest credit quality, which are backed by the full faith and credit of the issuing entity (such as the government), to bonds that are below investment grade and considered speculative.
When a bond is issued, the issuer is responsible for providing details as to its financial soundness and creditworthiness. This information is contained in the prospectus. If your intermediary is not able to provide you with a copy of this document, you should request a summary of the main features attached to the bond which you intend to purchase. Such features would normally include: information about the issuer, name of the bond (including date of maturity), current price, accrued interest (if any), frequency of interest payments, redemption information and ratings. Make sure that all information given to you verbally is put down in writing for future reference.
Country or Sovereign Risk: This is risk inherent in holding shares, bonds or other securities whose fortunes are closely linked with a particular country. If the country goes into an economic downturn, or its debt is downgraded, or the international investor sentiment just turns against it, your investments may lose value. Generally speaking, country or sovereign risk occurs in emerging markets rather than in developed economies.
Of course the very volatility of emerging markets also presents opportunities – although retail investors should exercise extra caution when investing in such securities.
Interest Rate: Bonds pay interest that can be fixed, floating or payable at maturity. Most bonds carry an interest rate that stays fixed until maturity and is a percentage of the principal or face value amount. Typically, investors receive interest payments semi-annually. For example, a EUR 10,000 bond with an 8% interest rate will pay investors EUR 800 a year, in payments of EUR 400 every six months. When the bond matures, investors receive the full principal or face value of the bond that is EUR 10,000
But some sellers and buyers of bonds prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating-rate bond is reset periodically in line with changes in a base interest-rate index.
Some bonds have no periodic interest payments. Instead, the investor receives one payment – at maturity - that is equal to the face value of the bond plus the total accrued interest, compounded semi-annually at the original interest rate. Known as "zero-coupon bonds", they are sold at a substantial discount from their face amount. For example, a bond with a face amount of EUR 20,000 maturing in 20 years might be purchased for about EUR 5,050. At the end of the 20 years, the investor will receive EUR 20,000. The difference between EUR 20,000 and EUR 5,050 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures.
Price: The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a *premium.
When a bond sells below face value, it is said to be selling at a discount.
Yield: Yield is the return you actually earn on the bond based on the price you paid and the interest payment you receive.
The yield to maturity tells you the total return you will receive by holding the bond until it matures or called. It also enables you to compare bonds with different maturities and interest payments. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face value) or loss (if you purchased it above its par value).
You should ask your intermediary for the yield to maturity on any bond you are considering purchasing. Your intermediary will also help you understand better how the yield to maturity is calculated.
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