Investing in Bonds

Most people associate investing, especially for individuals, solely with equities, and occasionally commodities. However until fairly recently 30-40 years ago, bonds were the more popular investment for private investors, however they have generally been replaced in most portfolios by stocks and shares. The purpose of this article is to explain what bonds are and the advantages of investing in them for private investors.

Bonds are essentially a fixed interest method of investing which can be applied to both countries and companies. If you buy a bond you are lending money to that company or country, and they will pay you interest on the loan, and then will pay you back the original amount when the bond matures – or finishes. The rate of interest is known as the coupon, so if you buy 5 year bond for $100 with a 5% coupon you will get $5 back each year, and then your $100 back at the end of the 5 years when the bond matures.

This may sound pretty similar to putting your money into a fixed rate savings account. However the difference is that bonds can traded – or bought and sold. So if you bought a bond for $100 with a 5% coupon but the company you bought it in starts to look unstable you may want to sell the bond because you are unsure whether you will get your money back as the company may go bankrupt. But as other investors are aware of this you may not get the original $100 back, you may instead get $80 because they think that paying $100 is not worth the risk.

However the investor who bought it will still get $5 a year in interest, as the interest is calculated on the initial amount, not the market rate, so they will in fact be getting an interest rate of 6.25% due to them buying it for $80, as well as the original $100 back at maturity. This sounds good, but if the company goes bankrupt they will probably lose their $80 and receive no interest. This also works in reverse, if a company is doing well the price of the bond will go up as investors are more confident in the company’s ability to pay the interest and the original amount back.

One other key concern with bonds is inflation, if you buy a bond that has a 5% coupon and inflation is 6%, you are effectively losing 1% of your investment a year. And it is unlikely other investors will buy it off you for what you paid, otherwise they would be losing money as well. So to sell it you would have to lower the price.

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