Bonds As an Investment Opportunity
In the financial world, bonds are one of the most highly leveraged products. In finance, a bond is a financial instrument of debt owed by the bond issuer to its bondholders. The most common forms of bonds are municipal bonds and corporate bonds. Bonds can also be either in individual investing where an individual would lend a business or the state some money, or may be in mutual funds. As long as the investor can recoup his invested principal plus interest after a set period, it makes for a good investment proposition.
A bond issues a promise to pay a specified interest rate on a certain amount of principal. Bonds generally represent debt obligations of the U.S. government or a corporation. When bonds are sold, the principal is paid to the holder, usually at the point of sale, and the remaining debt is paid by the issuer. If the issuer defaults, the principal and interest are repaid to the issuer.
Historically, bonds are categorized into two major categories: credit risk and non-credit risk
Credit risk refers to the inability of the issuer to pay the principal back on time. Non-credit risk refers to the inability of the issuer to pay the principal back within a specified period of time. A company that issues credit bonds must comply with certain credit risk requirements that are imposed by the Federal Reserve Board. issuer’s credit risk is determined by the amount of debt, history of debt repayment, liquidity, creditworthiness of collateral (if corporate or government), and the tolerance of the market for its debt obligations. Bond issuers are required to disclose certain information about their credit risk in the bond prospectus they issue to the investors.
Typically, bonds that carry higher interest rates than bonds with a lower credit risk are considered to be “investment grade bonds.” Bonds that carry lower credit ratings than investment grade bonds are referred to as “bond rated bonds.” The reasoning behind this classification is simple. As issuer’s payment capacity may fluctuate due to varied economic factors, the risk to an investor is higher if one of these bonds is purchased.
On the other hand, bonds that carry a high yield but have a lower total maturity are categorized as “put” bonds
Put simply, these bonds have a shorter duration. Generally, bonds with longer maturation periods have lower yield. As a result, the yield to maturity ratios of put bonds tend to be higher than those of the longer-maturity products. The reason for this is that the seller of these bonds is in a better position to realize profits from selling bonds with higher yields than when selling those with shorter maturburies. However, the reverse is also true; when the seller has less liquid capital, the bonds have a lower yield.
There are two types of investors who purchase bonds, namely, individual investors and institutional investors. While mutual funds are predominantly purchased by large institutional investors, individual investors mostly purchase them to obtain yield diversification. For example, there are mutual fund portfolios where most of the funds are concentrated on yields from blue chip companies. Likewise, there are bond mutual funds where the bulk of the funds is invested in junk bonds or other investment grade bonds. Bond funds are an attractive option for many investors.
If you are thinking of purchasing bonds, it is advisable to understand your risk tolerance and to identify what your immediate goals are
If you are looking for yield then you should purchase investment-grade bonds which carry the highest credit ratings. Conversely, if you are more concerned about credit quality of the issuer of the bond, then you can choose to purchase investment-grade bonds that have lower credit ratings. In this case, you will not be as exposed to market forces.
Many businesses issue bonds as a part of their fundraising efforts. Usually, businesses issue bonds to raise money for either the expansion of the business or for the acquisition of new products. When issuing bonds, businesses normally secure the money they are required to borrow by promising to pay interest during a specified period of time and/or by issuing payments to cover costs. A few bonds are used as financial instruments by entities such as corporations to raise money for both their short term and long term debts. Since bonds are considered relatively safe, most corporations issue bonds as a means of raising money.
What Is A Bond?
In the financial world, a bond is a legal obligation of the issuer to the purchasers. The most common kinds of bonds are corporate bonds and municipal bonds. Corporate bonds are bonds which are secured by the assets of a corporation. Municipal bonds are bonds which are secured by a municipal asset like a townhouse, building or cemetery.
These bonds are also classified according to risk: good debt (CDs), poor debt (bonds with coupons but not with guarantees) and good credit risk (certificates with guarantees but not with security).
Good debt bonds are the safest type of corporate bonds
as they have less chance of defaulting compared to poor debt ones and they carry a reduced rate of interest. On the other hand, poor debt corporate bonds carry a higher rate of interest, but their chance of defaulting is much lesser than the good ones. Good credit risk bonds, on the other hand, are usually issued by governments.
Now that you are aware of this basic information, it is time to move ahead and learn how to identify fraudulent bonds by going through securities industry publications such as American Municipal Securityurities Association, Security Investors Protection Corporation and others. These are the most reliable sources of information on corporate bonds that an investor can count on. Moreover, they can also act as a guide while dealing with brokers and dealers. One can also go through stockbrokers’ brokerage websites for additional details.
Once you know what kind of bond you are looking for, the next step is to understand the different terms that are used in the industry
One term you should know before buying bonds is the coupon rate risk. This term refers to the interest rate risk of an issuer face while repaying the bonds. It basically means that the issuer’s financing cost will fluctuate depending upon the current interest rate. This is mainly due to the fact that bonds are not purchased on a regular basis. As such, the interest rates change constantly.
There are other terms you need to know such as credit risk and high-yield bonds. Credit risk refers to any risk associated with an investment-grade bond, which is considered as lower credit rating. On the other hand, high-yield bonds are considered as high-risk securities. Basically, high-yield bonds carry a greater interest risk than any other kind of bonds. Thus, the price of these bonds will fluctuate depending upon the current market conditions.
A call option or put option is another important term you need to understand before buying callable bonds
This option allows investors to sell call options to their lenders at a certain price and thus buy or sell bonds depending on the opinion of the lender. However, note that unlike the underlying bond, the option has to be a call option in the first place to allow investors to sell it.
A bond is actually an obligation of an individual or entity. Bonds are long-term financial obligations which are issued by governments, companies, municipality, special institutions and even private individuals. To raise money from investors, bonds are normally sold in the form of stock certificates. However, note that there is a difference between the sale of stock certificates and the sale of bonds. Usually, when an investor buys a bond, he or she does not have to pay for the face value but rather, they can pay for a specified amount.
Generally, bonds rated BBB, B, C and A are regarded as high quality bonds since they have excellent credit ratings and excellent liquidity
When it comes to bonds, C rated bonds carry the lowest premiums among all other bonds. Since bonds of all grades are equal in value, it is very difficult to determine whether a bond is a high-quality or low-quality bond. Some bonds rated BBB are considered as junk bonds because of the high premiums paid to the issuer for such bonds. Junk bonds usually carry high interest rates and with poor liquidity features.
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