Bonds – Definition and How to Invest
Bonds are debt instruments issued by governments and companies with the aim to finance their budget or their activities. Buying a bond is like lending money to a government or to a company. As such, the main risk of a bond is the default of its issuer. Therefore, when picking a bond, one should estimate its default risk and compare it to the expected return from this bond. A bond’s return is the interest we get paid (known as coupon) against lending the money for the duration of the bond; that is until its maturity. In addition, any price appreciation or depreciation one incurs at maturity as compared to the paid price is also factored in the overall return. Therefore, the combination of both returns is defined as the real annual return of a bond, and is called the Yield to Maturity.
To have an indication of the default risk, one should look at the rating given by one or more of the three major rating agencies namely, Standard & Poor’s, Fitch, and Moody’s, who usually classify bonds according to their default risk. Although looking at the rating of a bond is essential when selecting a bond, it is also necessary to formulate an opinion of the real risk of default by conducting one’s own research and analysis. That is how one can occasionally find good bargains by keeping in mind that sometimes rating agencies exaggerate their reporting of default risk on such bonds.
Bond prices are very sensitive to interest rates. When interest rates increase, prices of existing bonds decrease as a result of bond traders flocking to buy the new high-paying interest rate bonds, while shying away from the lower interest rates of existing bonds. Therefore, it would be wise not to buy too much bonds when interest rates are low, because any increase in interest rates will negatively affect bond prices.