Sunday, September 23, 2007

Uses Of Bonds

As you have already learned, bond investments are interest earning and its value can appreciate or depreciate in relation to interest rate changes.

Bond is generally a safe investment. However, except for bonds from the government, bonds do carry the potential risk of default, no matter how remote that risk might be.

Bonds would appeal to those who want to receive interest income or to preserve and to accumulate capital. If you want regular returns of a certain amount of money, a bond will fit the bill very well.

Bond is a better alternative to savings and fixed deposits. If you wish to invest your money safely for a longer period of time, bonds serve this purpose better than fixed deposits. You can beat inflation and enjoy higher returns than fixed deposit rates.

Due to the conservative nature of bonds, it is one of the investment tools that could be added in any phase of your retirement portfolio. Your holdings in bonds would vary depending on your risk tolerance and investment time horizon.

If you are young and have many years away from retirement, you are most likely to build your nest egg by taking a fairly aggressive stance. However, it would be unwise to put everything into equity as it is a very volatile instrument and are generally the most risky. You would probably have a diversified investment portfolio that consists of bonds, equities and cash in varying allocation. Diversification offers some protection for your portfolio as the rising value of certain assets could help to offset the assets that are facing a negative impact. By adding bonds in an equity portfolio, it would enhance stability and reduce risk exposure as your capital in bonds would likely to be protected from equity market fluctuations.

If you are a few years away from retirement or have retired, you need to protect yourself from possible steep equity declines. You can shift from an aggressive stance to a moderately aggressive one by adding more bonds. As you receive a fixed amount of income that is paid regularly over the lifetime of the bond, the predictable cash flow from bond investment adds a necessary element of stability to the retirement portfolio.

As lower risk often leads to lower returns, the emphasis of investing in bonds generally does not lay in capital appreciation, but in, income generation and capital preservation. If you invest in bonds of good credit ratings, you will most likely get back your principal upon maturity. As it is possible to incur a capital loss if you were to sell before the bond matures, you will need to consider when you want the principal to be repaid and the kind of returns you seek, and take into account your risk tolerance.

Saturday, September 1, 2007

Bonds - Fixed Income Instrument

Having talked about bank deposits and forced savings through insurance product the past few weeks, today I shall cover another investment instrument that one can consider and that is Bonds.

What is Bonds?
When investing in bonds or fixed income/debt securities, you are actually lending money to finance a corporation or the government's operation, becoming a creditor of the corporation or government.

Bond investments are interest earning. It has a coupon rate which is the interest earning element and a maturity date. During the initial issue, a bond is sold at par value, or 100% of its face value, and the return (yield) is the coupon rate. Once a bond is issued, the coupon rate or interest is fixed and will not change throughout the term of the bond. However the price of the bond will change. This is because bonds can be bought or sold on the secondary market before they reach maturity. There is hardly a time when a bond is sold at par value. When a bond sells below its par value, it is said to be selling at a discount. On the other hand, if it sells above par value, it is selling at a premium.

A change in the price of the bond is caused by changes in interest rate. When interest rate rises, bond prices will depreciate. This is because new bond issues will have higher coupon rates than existing bonds. Therefore, bond prices will fall to compensate for the difference between the existing yield and the current market yield. Hence, an investor considering the purchase of the existing bond can earn additional interest by paying less (< $1000) for each bond and getting the same coupon rate. The opposite is true when interest rate in the market falls and new bond issues offer a coupon rate that is lower than the existing coupon rates. Bond prices will increase because whoever buys the bond at par value would be earning a coupon rate that is higher than market rate. This will result in excessive bidding for the bond due to its attractive yield. The price of the bond will then be bid up to the level where the bond offers a comparable yield as the current market yield, usually higher than the par value.

In summary:
When bond is sold at par, return = coupon rate;

When bond is sold at discount, return > coupon rate;
When bond is sold at premium, return < coupon rate

Henceforth, when investing in bonds, not only will you earn interest but also get the opportunity to sell at a premium when bond price increases. You can also choose to hold it till maturity should bond price decreases.