Things you should know about the Bond Market
The bond market is one of the largest securities markets because bonds are the least volatile securities out there and will play an important role in diversifying your portfolio. Although bonds provide fewer returns than stocks, it is considered as a safe investment and known to provide regular passive income. Which makes them an important part of your portfolio based on your risk tolerance.
So, some basic knowledge about them like how do they work, how to use them, and what are the risks of owning them will help you make better investment decisions. And this article is all bout it.
What is a Bond?
A bond is simply a loan that you lend it to a company or an organization or sometimes government. Unlike buying stocks in a company, buying a bond doesn't make you a partial owner you are simply lending some money, which is considered as an advantage and disadvantage as well. Companies issue bond to grow their business so, If you buy a bond of a certain company you are basically lending some money to that company(borrower) since it is a loan the company will pay you some amount as interest annually and it will repay you the Face value(issuing price of the bond) after some period of time.
For example, a company might issue a bond that worth Rs.1lakhs that pays a 5% interest rate for 10 years. so, when you buy their bond, you are lending the company Rs.1lakhs that they can use it for their development. In return, you'll get paid Rs.5000 as interest every year for 10 years and once the period is over you will get your Face value(Rs.1lakhs) repaid.
That period of 10 years is called the bond maturity period.
5% interest rate that the bond issuer(company) pays you is called a coupon rate.
And the issuing price of the bond(1lakhs rupees) is the face value of the bond
But you know what the coupon rate is not the actual rate of return of the bond i.e the 5% interest rate is not what you will receive! confused and surprised? We will explain it.
The yield of a Bond
Cupon rate is just the predetermined interest rate that the bond issuer offers the investor and it is calculated as the percentage of the face value of a bond. Since bonds are bought and sold in the secondary market the bond price will fluctuate and be different for its face value, in such a scenario the rate of return will be different from the coupon rate and this rate of return is known as the current yield. The current yield tells us how much the rate of return you will earn if you buy the bond and hold it for a year. But the current yield of the bond is not the actual return that you'll receive if you hold it until maturity.
current yield is calculated by [Anual interest payment / Current market price of the bond]
so when the price of the bond goes down the yield of the bond increases and vice versa.
i.e The yield of a bond is inversely related to its price. Less demand for the bond pushes the bond price down and a bond with a price lower than it's face value produces higher returns.
Bond Investment Strategies
well, There are types of Bond investment strategies so, that's saved for another article, and here are common bond investment strategies.
Passive Bond Management Strategy
(Bond) ~~~~~~~> (maturity)
This strategy is followed by a typical bond investor. Passive bond management strategy also called as buy and hold strategy is basically buying a bond and holding it until maturity, this strategy is considered as safe and produces a regular income that can be reinvested. A low-risk tolerance person will buy a government bond rather than a corporate bond in buy and hold strategy. Since government bonds as considered to be less risky than corporate bonds as corporates might default the repayment at the time of maturity. Low-risk bonds such as government bonds and municipality bonds well suit the passive bond management strategy.
The Bond Ladder Strategy
Bond ladder strategy is investing in multiple bonds with a different maturity rate, This strategy reduces the interest rate risk and allows you to invest at regular time intervals and unlike passive strategy, you have more cash liquidity in hand.
For example, say you buy 5 bonds with a different maturity date of 3,5,6,8 and 10 years, once a bond matures you can reinvest it. since you invested bonds at different maturity rates and coupon rates, interest rate risk is reduced.
The Barbell strategy
In the barbell strategy, you split your investment into long term bonds and short term bonds. which is basically a bond with longer maturity and a bond with a shorter maturity period.
For example, you buy 2 bonds with a maturity period of 5 years and 10 years. This strategy gives you more financial flexibility.
Why should you have bonds in your portfolio?
Well, as we learned about a bond and how does it work now, here is why you should have bonds in your portfolio.
Diversification Investing a single stock or a single asset class is risky especially when the business doesn't perform well or during the times of crisis, investment losses its value and you might make a loss so, spreading out your investments by buying bonds and other assets, since bonds are considered to less volatile than stocks, owning bonds reduces the risk of your portfolio.
Regular Income Unlike stocks bonds you a regular income as interest, which can be reinvested or can be used to buy stocks, stocks pay you dividends though but only a smaller amount which is less than bounds.
Capital protection Bonds repay you the capital which you invested, once the bond matures. this makes bonds more appealing than stocks to investors who prefer safety over the returns, especially for people who have a low tolerance to risk. which brings us to another pro.
Less volatile Blonds are generally less volatile than stocks. bond price changes less compared to the stocks but stocks outperform bonds.