Companies, governments, or organizations that borrow money issue debt securities in return for bonds. A bond is a negotiable debt instrument, while a stock is a negotiable instrument of ownership. A lender may decide to sell a debt instrument to another person who acquires the right to the interest payments and the principal invested.
Most bonds have a fixed interest rate. This interest is called a ‘coupon.’ Most bonds have a specific maturity. At the end of this term, you must repay the principal. Short-term bonds usually must be repaid within four years; bonds usually after four to twelve years. Long-standing bonds can have a ripeness of thirty years or even more, but such cases would be rare.
Government Bonds
Of course, not all governments are equally stable. Therefore, government bonds from emerging countries and European peripheral markets can be riskier than bonds from developed countries, such as the US, Japan, and the UK. On the other hand, other countries’ governments are safe because they have time to cash them back, have nothing to do with the global economy, and are not at any risk; they are just like cash in different types.
Company Bonds
When a company needs capital, it can issue bonds, which are expressed in the bond rating. The risks associated with corporate bonds depend on the company’s overall health, which we’ll discuss later in this article.
What is the Bond Market, and How Can You Invest in Bonds?
Investors can take advantage of changes in the stock or bond market, which is where stocks and bonds are sold or issued. Investors usually buy their bonds through a bank or broker. However, you typically must put in a high minimum amount when purchasing bonds, which puts some investors off.
However, you can afford a lower investment if you buy bonds through a bond fund or ETF (exchange-traded fund). In addition, a fund or ETF contains several bonds, allowing you to diversify your investment. Therefore, investing in a fund or ETF involves less risk than buying bonds issued by just an entity.
What are the Advantages and Risks of Bonds?
The main advantage of bonds is that they are generally less risky than stocks. In a bankruptcy, a company must repay the bondholders and creditors, only the shareholders. It means that when a company performs well, the return on bonds is likely lower than the return on stocks. This lower risk also has a downside: because bonds have a lower risk premium, the expected long-term return is lower than equities. In addition, bonds pay a fixed interest rate, while stocks increase in value as the value of a company increases.
Here are the main risks of bonds
Credit risk
It is the risk that the issuer will not repay the principal (or part of it) invested or that you will not pay the interest. It is usually said that government bonds have a lower credit risk than corporate bonds. That’s because governments can raise taxes when they need more money. However, there are numerous examples of governments that did not (entirely) repay their bonds in the past. In emerging markets, the credit risk is significantly higher.
Interest risk
The value of a bond with a fixed coupon (fixed interest rate) moves opposite the market interest rate. When market interest rates rise, investors can buy new bonds with a higher coupon. As a result, bonds already issued with a lower coupon automatically become worthless. On the other hand, the value of a fixed-rate bond rises when the market interest rate falls.
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