Where To Invest? - Bonds

Today I shall look at Bonds. Bonds are typically underappreciated as typically, the first thing that comes to most people's minds when they think of investing is the stock market. After all, stocks are exciting. The swings in the market are very well covered in the daily newspaper and TV broadcasts such as CNN and Bloomberg. In contrast, Bonds, do not have the same sex appeal. Most people do not even know what they are and how it works. The Return On Investment on Bonds tends to work opposite of the stock market, i.e., when stocks are doing well during raging bull market, bonds tend to do badly! However, when it is bear market, bonds act as the safeheaven for investors on a more conservative scale.

So what are Bonds? Basically, a company needs funds to expand into new markets, while governments need money for everything from infrastructure to social projects. Typically they need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to the public. Investors who subscribed to the bond are in fact the lenders, whereas the borrower becomes the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor). The return for the investor is in the form of interest payment (termed as coupon), which is fixed at a predetermined rate over a fixed duration. The issuer has to repay the amount borrowed (known as face value) upon the maturity date. e.g, you buy a bond with a face value of $10,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of $800 ($10,000*8%) of interest per year for the next 10 years. When the bond matures after a decade, you'll get your $10,000 back.

Bonds normally have a negative correlation with interest rates. When interest rate goes up, bond yield goes down, and vice-versa. So you should start buying bonds if you spot a downtrend in interest rates and vice-versa.

Bond is different from equity (stocks) in the sense that a bond holder is treated as a creditor of the issuer, whereas equity holder is a shareholder. A bond holder stands a better chance of claiming the assets than a shareholder upon filing of bankruptcy by the company. In another words, a bondholder gets paid before a shareholder.

As the return on investment for bond is predictable, the potential return for bond is generally less exciting than equity stocks. Thereagain, bond is less risky compared to equity. Most investors invest in bonds as a form of asset allocation, i.e., instead of putting all their money in one basket (eg., equity), they allocate some percentage of investment in bonds...therefore leveraging the effects of both bull and bear markets.