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What’s it: Bonds are debt securities with a promise to pay back the principal at maturity and pay coupons regularly. They usually mature in more than 10 years. And we distinguish them with notes, which have a maturity of 10 years or less. Next, there are bills, which mature in less than one year.
Then, the above definition can be broader. For example, some bonds may not pay coupons – called zero-coupon bonds – or have no maturity – called perpetual bonds.
Bonds may be issued by companies – called corporate bonds. They issue bonds – as an alternative to issuing shares – to raise funds to finance investments.
Then, bonds may also come from the government, both national governments – called sovereign bonds – or local governments – municipal bonds. In addition, supranational institutions such as the World Bank also issue bonds.
For investors, investing in bonds offers them regular income, namely coupons. In addition, when they mature, they receive the principal they invested. And, as long as they are not yet mature, they also have the potential to get capital gains when bond prices rise.
What is the difference between a bond and a bank loan?
Bonds and bank loans are debts. Bonds are similar to bank loans but work a little differently. Take corporate loans as an example. In this case, the bank lends the company some money. Loans usually come from one bank. But, sometimes, some banks may form a consortium to lend. The company then pays regular installments, which include principal and interest.
Meanwhile, when companies borrow through bonds, they borrow from investors. Banks are among the potential investors. In addition to banks, other investors include pension funds, insurers, and even individuals. Long story short, when issuing bonds, companies borrow from many parties.
When buying bonds, money flows from investors to companies. As compensation, the company regularly pays coupons to bondholders. And when it’s due, they pay the principal. So, different from bank installments, regular installments to pay bonds only involve interest.
What is the difference between bonds and stocks?
Bonds are an alternative to stocks for fundraising by companies. While the former results in an obligation to pay coupons and principal, the latter does not. Shares represent ownership in the company. So, for example, if we buy it, we become shareholders in the issuing company.
Issuing stocks and bonds increase the company’s capital. However, unlike bonds, stocks do not contribute to increased leverage. Rather, it increases the company’s equity.
In contrast, issuing bonds increase financial leverage because the company has higher regular liabilities. They have to pay for the coupon and principal. Failure to meet obligations can lead the company to default.
Meanwhile, issuing shares does not result in regular payments. The company does not have to pay regular interest, principal, or the like. However, shares often carry voting rights, which allows investors to influence company decisions during shareholder meetings. And voting rights are not on the bonds.
Are bonds a good investment?
Bonds are a good alternative for diversifying a portfolio. Most bonds will pay interest (called a coupon) to us periodically. In addition, we will also receive the principal when it is due.
However, some bonds do not offer coupons but are sold at a discount. We call them zero-coupon bonds. They allow us to get high capital gains from rising prices. Because they do not offer coupons, they are usually sold below par value to attract investors, much less than conventional bonds.
Like stocks, bond prices change over time. The price increase allows us to make a profit when selling it. The difference between the selling and purchase prices is known as a capital gain. However, sometimes, bond prices can also fall, for example, due to an increase in interest rates, causing us to suffer a capital loss.
Risk factors
Bond prices are sensitive to market interest rates and are inversely correlated. Prices will rise (yield falls) when interest rates fall. Conversely, prices fall (yield rises) when interest rates rise.
An increase in interest rates usually occurs when inflationary pressures rise. During this period, central banks will usually introduce a tighter monetary policy. As a result, they raised interest rates to moderate inflation, leading to higher market interest rates. For this reason, inflation is another risk when we buy bonds.
Bond risk also comes from creditworthiness. We can assess creditworthiness from the credit rating assigned by the rating agency. For example, an AAA rating has the highest creditworthiness than an AA rating or below. Therefore, we expect AAA-rated bonds to have the lowest probability of default.
Then, if we aggregate, bonds rated BBB- to AAA represent investment-grade bonds. Meanwhile, bonds under BBB- represent non-investment grade bonds or junk bonds. Junk bonds offer high yields because they are riskier – hence, they are also called high-yield bonds.
Maturity also affects our risk when holding bonds. Bonds with longer maturities carry more uncertainty about the coupon and principal payments. Thus, they are riskier – for this reason, they offer higher interest rates.
Invest in bonds or in stocks
Bonds and stocks offer us profits when their prices go up. We can sell it and get a capital gain.
In addition to capital gains, we receive coupons regularly when buying bonds. And we have the potential to receive dividends when we buy shares – although not always. However, in general, bonds and stocks carry different risks.
Bonds are considered safer than stocks. This is because they offer us periodic income from coupon payments. Meanwhile, the company may pay dividends regularly, and it may not.
Stocks don’t always pay dividends.
Dividend payments depend on company policies and performance. Not all companies pay dividends regularly. For example, some companies prefer to withhold dividends to support future business growth. And they hold profits as retained earnings to increase equity capital.
Stronger equity capital allows the company to finance expansion through internal capital. If it runs successfully, the company can generate more profits. We then expect them to distribute dividends. Long story short, we do not receive dividends today to get them in the future with a larger nominal.
However, some other companies do not pay dividends at all due to poor financial performance. Instead, they posted a net loss. Thus, losses expose them to declining equity capital instead of paying dividends and having stronger internal capital.
For this reason, there is uncertainty about dividend payments. Therefore, if you are pursuing regular income, choosing a company with a good track record of paying dividends is a good guide. However, even if they paid dividends in the past, that does not guarantee they will distribute them today and in the future.
Bonds always pay coupons.
Bonds provide us with a steady and regular income stream from coupons. Most bonds do. The exception is for zero-coupon bonds, although they are rare.
Then, coupon payments do not depend on the company’s financial condition. Companies still have to pay coupons even though they record losses because bonds represent liabilities. So, when we buy it, we receive interest income while waiting for the bond to mature and get the principal back.
Coupon payments ultimately offset the volatility in bond prices. Like stocks, we can buy and sell bonds in the secondary market. Once issued, they will be traded continuously to maturity – as long as they are liquid, and their value will fluctuate like stocks.
However, if we hold the bond to maturity, the fluctuations will not affect the coupon payment. The face value will also not change. Price fluctuations only occur as long as it is not yet due, and they will always be equal to the face value when it matures. If we don’t actively trade bonds, we don’t get capital gains from the difference between the selling price and the buying price.
What are the advantages and disadvantages of bonds?
Bonds may not provide as high a return potential as stocks. However, they also do not carry as high a risk as when investing in stocks. Bonds pay interest regularly, so they can help us generate stable and predictable income. Investing in these instruments makes us less likely to lose money than stocks.
Besides cash, government bonds are the safest and most liquid investments. Short-term bonds can also be a good place to invest in an emergency fund or the money you need immediately.
However, we also need to consider the risks inherent in bonds, as described in the paragraph above. So, for example, if our risk tolerance is low, AAA-rated bonds with short maturities can be an option. On the other hand, if we want a slightly higher return, we can buy the one with longer maturity and a lower rating. Then, if we have a high tolerance for risk, buying stocks may be the right choice instead of holding bonds.
What are the features of bonds?
Several features distinguish one bond from another. For example, we differentiate them by credit quality, measured by their rating. In addition, we differentiate bonds into investment grade and non-investment grade bonds. Investment grade means having a BBB- or higher rating.
On the other hand, if bonds are rated below BBB-, we refer to them as non-investment grade bonds or junk bonds. Junk bonds are also known as high-yield bonds because their high risk of default makes investors only willing to buy if they have high yields.
Then, we also differentiate bonds based on their maturity. The issuer may issue bonds with tenors of more than 10 years or more. If they mature in 10 years or less, we specifically refer to them as notes. And, if less than 1 year, we call them bills. Overall, bonds with maturities for all tenors we call debt securities.
Then, in general, the longer the maturity, the riskier the bond. For this reason, bonds with longer maturities will offer higher interest rates.
In addition to credit quality and maturity, we also differentiate bonds based on variables such as issuer, face value, coupon, currency denomination, embedded provision, and seniority.
- Issuers: corporate bonds, sovereign bonds, local government bonds, and supranational bonds.
- Face value: jumbo bonds and mini-bonds.
- Coupon rates: fixed-rate bonds, floating-rate bonds, and zero-coupon bonds.
- Currency denominations: Eurobonds, Samurai bonds, Euroyen bonds, Eurodollars bonds, and local currency bonds.
- Embedded provision: putable bonds, callable bonds, and convertible bonds.
- Seniority: secured bonds, unsecured bonds, and subordinate bonds.
What to read next
- Bonds: Types, Features, Risk, Pros and Cons to Investing In It
- Complete Bond Features. What You Need To Know.
- Bond Issuers: Who Are They?
