Investing in bonds and understanding bond concepts, coupons, par value, ratings, and more.
What is a Bond?
A bond is a debt security issued to raise funds and the issuer gives you a promised rate of returns. It is a long-term fixed interest security with a maturity above 1 year. A bond’s pricing is affected by the coupon rate, principal (par) value, years to maturity, and rate of return (discount rate).
- Supranational bonds: issued by internal groups/powers
- Government/sovereign bonds: issued by governments
- State/non-government/municipal bonds: issued by state-governments
- Quasi government bonds: issued by quasi-government agencies
- Corporate bonds: issued by companies
- Individual/celebrity bonds: issued by individuals
What do You receive as a Bondholder?
- Interest payments (coupons)
- Your principal sum on maturity (par value)
Bonds used to be perceived as low-risk investments which tends to move opposite of interest rates & shares. A typical asset portfolio in the old days would consist of shares & bonds. Today, however, bonds are at risk of failure from companies (and even governments!). Depending on the bond rating, bonds can range from a low-medium to high risk investment.
Bond Investment Risks
- Interest Rate Risk: Changes in interest rates affect bond value
- Call and Prepayment Risk: Bonds can be called early and principal returned early where future interest payments on principal will not be paid. This is often prompted by a fall in interest rates.
- Yield Curve Risk: Change in yield curve can affect returns. If market interest rates (yields) increase, the price of a bond will decrease (and vice versa).
- Reinvestment Risk: Principal and interest risk being invested at a lower rate (in a low interest rate environment). This is especially if bonds are called early in a declining interest rate environment.
- Default Risk: Risk of credit worthiness of the issuer.
- Downgrade Risk: Risk of bond rating falling.
- Liquidity Risk: Risk of bond being unable to be disposed/sold.
- Exchange Rate Risk: Risk of bonds in foreign currency.
- Sovereign Risk: Changes in government policies affecting the repayment of debt.
There are bond rating agencies that assign a creditworthiness score to bonds issued. Bonds are analysed based on the bond issuer in terms of 4Cs for a specific debt issue.
It has become easier for individual investors to buy bonds in recent years. However, bonds still require typically $25,000 (RM100,000) and above to invest for some degree of diversification. If you have a smaller amount to invest, consider bond funds or other lower-risk/fixed interest investments.
- Credit Rating
- Yield-To Maturity (YTM)
- 1 year: money market instruments
- 2 – 5 years: notes
- 6 – 10 years: intermediate bonds
- Above 10 years: long-term bonds