Introduction to Bond Investing

Bond investing is another investment you might want to consider. Generally, as a company grows, it may come to a stage where it does not generate enough cash internally to pay for expansion. Because of this financial need, most businesses have to sell a portion of the company to the general public by issuing additional shares.

Alternatively, they can issue bonds as well.

The difference between stocks and bonds can summed up in one simple comparison; equity versus debt. Stocks represent equity ownership whereas bonds represent debt.

Bonds are debt securities in which the investor loans money to a company or government. These companies or governments borrow the funds for a defined period of time at a specific interest rate. They issue investors a certificate or bond that states the interest rate (coupon rate) that will be paid, together with the principle on the maturity date. Bonds are known as fixed income securities because you know the exact amount of money you will get back, provided you hold the bond until it matures.

So, in bond investing, you are not really buying anything. You are making a loan to someone. Usually, government is the biggest seller of bonds.

Why does the company or the government not borrow the money from bank? Large organizations may need far more money than the average bank can provide.

They may issue more shares but this decision will dilute the earning of each share and hence existing shareholders may not agree. The alternative solution is to raise money by issuing bonds to the public. Each investor then lends a portion of the capital needed. A company needs funds to expand into new markets while governments need money for infrastructure development or social programs.

Corporate bonds, also known as private debt securities, are issued by corporations. Such bonds are privately placed with investment institutions. They are also traded on the secondary market by finance companies and discount houses.
Governments are more secure than any other corporations. Their default risk, which is the chance of the debt not being paid back, is extremely small. The reason behind this is that a government will always be able to bring in revenue through taxation. A company, on the other hand, must make profits, which is far from guaranteed. This means the company must offer a higher yield to entice investors. This is a typical risk and return trade off situation.

The bond rating system helps investors distinguish a company’s credit risk . Blue chip firms, which are safer investment, have high rating while risky companies have low rating. There are rating agencies, which are independent, to analyse the credit risk of their bonds. They provide a rating scale for the benefit of bond investors.

Just like mutual funds or unit trusts, bond funds are collective investment schemes that pool money from many investors for the purpose of bond investing. Alternatively, some of the bond products are sold to individual investor directly.

Typically, the interest rate on a bond is higher than that on cash deposit (CD) in the bank. As a result, if you are saving and you do not need the money in the short term, bonds will give you the greatest return without posing too much risk. However, the longer the bond pays out, the greater the risk, and better returns as well.

A bond that is matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Apart from the risk, inflation will also eat up the value of your money if the bond matures after a longer period of time. Hence, in general, the longer the time for maturity, the higher the interest rate.

Between stocks and bonds, stocks carry more risk than bonds, but stocks are also giving a better return. Having said that, bond investing is carrying risk as well. Two significant risks are credit risk and interest rate risk.

When you buy a stock, you become a company shareholder. You have the right to vote in the company’s Annual General Meeting (AGM). You are also entitled to dividends paid by the company. You can participate in rights and bonus issue. As the wealth of the company increases, its stock will be recognized by other investors and the stock will command a better price. You can then sell that stock at a higher price.

But the bondholder does not share the profits made by the companies. He or she is entitled only to the principle with interest. Bond gives slow, steady and predictable returns. Thus, bonds outperform stocks at certain times in the economic cycle. Investors who diversify their portfolios by including bonds are able to stabilize returns when the stock market is lagging.
However, this does not mean that bonds will improve when the stock market is down. It is just that bonds will not crash like stock market. Simply put, bonds will help smooth out the bumps when a recession comes around.

Bottom line, bonds are safe and suitable for conservative investors (e.g. investing for retirement). However, stock market is still the place to go if you expect greater returns.

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