Tuesday, 7 February, 2023

What are bonds?

Many of you have probably borrowed money from a bank. Have you considered that you too could be a lender to a company or a government and earn money from it? Investing in a bond allows you to do just that. Before you commit your hard-earned cash, here are the basics you need to know about bonds.

What is a bond?

A bond is best understood as a loan agreement between you, the investor purchasing the bond and an issuer, the government or company borrowing your money. A long-term debt security (a year or more) which gives its owner a right to interest payments on specific dates.

Terms

Bond

Long-term loan agreement between an investor purchasing the bond and a government or company borrowing their money.

Credit rating

A measure of a company or government’s ability to pay its debts.

Coupon

The money an investor receives twice a year for the duration of the time that they hold the bond.

Diversification

An investment strategy whereby an investment portfolio contains a range assets with the aim of limiting the investor’s exposure to risk.

Face value

The original value of the bond to be repaid at maturity.

Fixed income security

A type of investment which pays an investor coupon payments for the years until its maturity or until it is sold.

Issue price

The price at which the bond is originally sold.

Maturity date

The date on which the bond expires when investors receive their final interest payment and their original investment.

Security

An item with that can be bought or sold for money.

Treasury bill

Short-term (a year or less) loan agreement between an investor purchasing the bond and a government or company borrowing their money.

Yield

The total return you receive on your investment if you hold it until maturity.

How do bonds work?

When you buy a bond, the institution offering the bond will lay out certain conditions upfront including how much money they need, how long they need the money for, and how much interest they will pay you every year that they have your money. For as long as you hold the bond, you are entitled to coupon payments at a frequency agreed upon, often twice a year.For example, if you buy 10-year Ugandan government bonds worth UGX 1,000,000 paying a 10% interest rate, you will receive a coupon twice a year of UGX 50,000. After the bond expires, you should receive your original investment (principal) in addition to your final coupon payments. Therefore, if you keep this bond until its maturity date, you will receive your UGX 1,000,000 and your last coupon payment.

Who issues bonds?

Bonds are most commonly issued by governments and companies.
Companies often use them as a way to raise money for purchasing or expanding their businesses.

Governments regularly issue bills and bonds to supplement their budget shortfalls, finance infrastructure projects and to deal with the consequences of unforeseen events.

How do I make money from bonds?

  1. Coupon payments: Most treasury bonds pay coupons twice a year.
  2. Selling: At any point, you may sell your bond at a time when its market price is higher than what you bought it for, earning you a profit in addition to the coupon payments you may have already received.
  3. Holding until maturity: You should receive the full sum of your original investment along with your final coupon payment.

Why should I invest in bonds?

  • Income: Treasury bonds can provide an additional source of income with the interest payments you receive twice a year which can provide a stable, reliable and potentially generous income stream depending on the value of your investment.
  • Low risk: The risk to your investment is relatively lower than other investments because it is guaranteed by a Central bank, many of which have a good track record of honouring their debts.

Lower risk = lower returns while higher risk = higher returns.

  • Liquidity: Treasury bonds are some of the most liquid assets available because of the relative ease with which they can be bought and sold in comparison to other assets.
  • Diversification: Investing in bonds can help to balance risk in a diversified investment portfolio because they are lower risk and more liquid than some investments such as real estate.

What are the factors that could affect my returns?

Interest rates

Bonds are sensitive to changes in interest rates which impact their value.

Interest rates move in opposite directions to bonds. New bonds will be cheaper when interest rates are rising and more expensive when interest rates are falling.

Therefore, if new bonds are sold by the Central Bank at lower interest rates than the bonds you already own, the value and demand for your bonds will increase while the selling of new bonds at higher rates will reduce the value of your bond, potentially earning you less money when you want to sell your bond.

Credit risk

Credit risk refers to how likely it is that an investor will lose money from their investment. For government debt, this is most widely determined by credit ratings. A credit rating is an opinion of how likely it is that a company or government is likely to honour its repayment obligations to you.

It is important to remember that while government bonds are lower risk than most asset, like every other asset, they are not risk free and there is no 100% guarantee that a government will honour its debts.

A rating downgrade signals higher risk for investors in the bond, potentially resulting in higher coupon rates for newly issued treasury bonds as a way to attract investors.

An upgrade signals lower risk for investors in the treasury bonds, potentially resulting in lower coupon rates for newly issued treasury bonds.

Costs

Fees and charges have to be accounted for when planning your investments. Depending on your country, you may be taxed on the earnings from your bonds.