The rate of return on a bond that a bondholder receives is called the bond yield. But first let’s get to know what a bond is. A bond is essentially a loan to an institution, of which you’d expect a fixed rate of interest paid back periodically until the bond maturity date. On the day of maturity the principal amount is paid back to the investor along with remaining interest payments. Bond prices may be affected by changing interest rates and level of inflation in the economy.
Bond issuers may be governments or corporate companies. Government bonds help raise money to fund infrastructure projects of a country and corporate bonds help the growth of a company. Government bonds are low risk as they are known to make their regular interest payments as governments are likely to raise taxes to pay their bond investors in periods of difficulty. But corporations may go bankrupt leaving the bond holder at the mercy of what the bankruptcy court decides as the amount to be paid to it’s bond holders.
A $1 million debt issue may be allocated as $1000 bonds. But once they hit the open market, the prices may vary. When the prices go up, they are called premium bonds. Buying a premium bond gives an investor lesser return as they paid more for what it’s actually worth.
If the issuer defaults on the debt, this affects their credit rating and the future outlook of the bonds they may bring to the market. Interest rates may be higher on these future bonds, which is riskier for the investor but profitable as well.
Rising interest rates will negatively affect the bond market as investors may not find a market for the bonds they own. Consider a bond with yield at 5%. If the interest rates were to rise above 5% in the economy, the bond with lower yield will not look attractive, bringing down the bond value. If interest rates were to go down below 5%, more people would find the yield at 5% more attractive which pushes the bond prices up due to higher demand and early investors are able to pocket handsome returns.
Bonds maturities range from 1 to 30 years. Investors choose a bond of longer maturity when they are certain that the rates would rise in the future. Bonds of shorter maturity period are chosen to make quicker returns in a market with downward rates.
This article is part of an on-going series on investing. Use category ‘Money’ to browse them all at once.
