Have you ever tried borrowing money from a friend? How about doing the opposite — lending money to a friend?
If so, you are closer to understanding the basic concepts behind bonds and other debt instruments like bills, notes and commercial papers, which are also known as fixed-income investments.
Bonds are nothing more than glorified IOUs sold to the public by an organization — government or corporation — called the bond issuer. To invest in a bond issue, you simply buy it from the issuing entity. In effect, you are technically lending or loaning your money to the bond issuer and they are also obliged to pay you back the borrowed money, plus some forms of interests. Bonds are known as fixed income securities, because bondholders can expect to be paid fixed amounts of money.
In the Philippines, bonds are usually issued by large corporations and the national government as a way of raising capital to fund specific venture, project or obligation.
If you are interested in investing in bonds, it helps to be familiar with its own lingo.
Here are some of the most common terms that you may encounter:
- Par value – also called the face value, this is the amount of money you will receive at the bond’s maturity date.
- Coupon rate – this is the amount of money you may receive periodically, say quarterly, until the bond matures. On the part of the investor, the coupons are interests his money is earning as a result of the investment.
- Maturity date – this is the time when the bond issuer returns the par value (say, principal + interest) to the bondholder.
- Call – is a feature of a bond that allows the issuer to pay back the loaned money before the bond reaches maturity. This is applicable to a special type of bond known as Callable Bonds.
- Bondholder – the investor who buys the bond and who, in effect, lends his money
- Bond Issuer – the organization (a corporation or a government entity) who borrows money from the public by issuing bonds.
Basic Types of Bonds
No matter who issues the bonds, they can be distinguished from each other in the manner in which they pay out interest to the investor.
1. Regular Bonds. They are much like the loan agreement friends make with each other when one wishes to borrow money from the other. The bond issuer makes a series of periodic interest payments to the bondholder and then pays the principal at maturity date.
2. Callable Bonds. Fortunately or unfortunately, bonds don’t necessarily reach their maturity date. The call option is a feature a Callable Bond which allows the bond issuer to pay back the bondholder the principal amount prior to the bond’s maturity date.
3. Zero-Coupon Bond. This type of bond doesn’t pay interest at all during the term of the bond, but the bondholder collects the entire principal plus interest when the bond matures. Here is another variation: The investor gets the par value at maturity date, but with no interest. Instead of interest payment at the end of the term, the bond sells lower than its par value. You profit by the difference between the purchase price (which is discounted) and the par value which you will get when the bond matures.
How to make money from bonds
If you’ve been following from the previous paragraphs, you’ll quickly notice that the most obvious way of making money from bonds is by collecting interests or coupons.
The other less obvious way is by trading bonds on the secondary market. To put it simply, you can sell your bond holding in three ways:
- at a discount – lower than its face value; meaning your at a loss.
- at premium – higher than its face value; you gain here, ideally this is the way to go.
- at par – you just break even.
I won’t go into the complex details of trading and valuation of bonds in this article. But, in a nutshell, what this means is that bond prices do fluctuate as a function of the current interest rate and to the bond’s duration (time to maturity).
Why invest in bonds
Some investors prefer the predictability of income offered by bonds compared to other investment instruments like stocks and real estate. Unlike stocks which are subject to high volatility, bonds are somewhat stable.
Bonds are a perfect match to conservative investors whose top priority is capital preservation plus a little bit of predictable income along the way.
And finally, investing in bonds is a good way to diversify your investments. As they say, don’t put all your eggs in one basket.
How to invest in bonds
There are basically three ways you can invest in bonds:
1. Directly from the issuing company, through a broker, where you get a bond certificate as proof of your bondholding. This would require a big amount of investment capital. This is usually done by large companies such as banks and their trust departments, mutual funds, insurance companies, etc.
2. Indirectly through banks and other big financial institutions. If you don’t have much investment capital to begin with, this is your other option. Some banks would offer retail bonds to their clients with as low as P 5,000 investment capital.
3. By investing in Bond Funds. These are Mutual Funds whose portfolio consists of bonds in larger proportion with a few Cash Equivalents added into the mix. This is also a cheaper alternative compared to going direct. And the good thing is, when you buy shares of a bond fund, you automatically achieve instant diversification among different bond issues since Bond Mutual Funds invest in several corporate issuers as well as the government. Philam Bond Fund is an example of a Mutual Fund which invest mostly in corporate bonds and government securities.
Without you knowing it, you could actually be indirectly investing in bonds already. The savings deposit that you put in the bank or credit cooperative doesn’t just hide there in the vault and magically earn interest on your money. You’re not aware what they do with the money, but they are investing it somehow. When you buy a participating life insurance policy, a portion of your premium is invested in bonds.
So, there you have it, our gentle introduction to Bonds as investment vehicle. Hopefully, I was able to shed some light on the mystery of this little known investment.
Meanwhile, I’d like to share this video as a way of supplementing the discussion we have in this article. Please watch. It’s a good explanation on the basics of bonds.