Wednesday, December 24, 2008

Basic Understanding of Bond

Usually, when we talk about investing, people will be so excited (or sad) to tell you how much they have made from stock markets (or how much they have lost). If you brought up the topic of investing in bond, people will be shunned away from the conversation. Well, given the broad publicity & coverage about stocks/ equities in all major newspaper as well as investment magazine, I wouldn’t be surprise that bonds do not generate the same sex appeal as stock investing

I’m not that certain about bond market here in Malaysia, but in more developed financial market such as US, the financial institutions do provide their clients with the service of buying government securities. What they need to do is to open an account with a bond broker which normally requires a minimum of $5000 deposits

Investors often overlook bond investing as normally the return is not that high compared to stock market. But in the bearish period such as now, it’s just too risky to throw our hard earned money into the wave of volatility. Not even investing in unit trusts fund is save for now (I lost nearly 70% of my investment). So in US, increasing number of people have chosen to throw their money into buying government securities, even though the interest rates are near to 0%. They do so as they perceive the chances of government to go default is very low. Why is it so? This is because government can always payback bond investors by the way of higher taxation. As such government bonds are also popularly called risk-free assets

Who & why issue bonds?
Government issues bond for various purposes. From infrastructure development to welfare programs or even to the extent of bailout. Firms issue bonds as they may want to expand the business, purchase of capital goods etc. The thing is, large organisations often need more cash than an average banks can provide. Therefore they also seek funding from the investing public

How bonds & stocks differ?
In bonds we are the lender/ creditor to government or firms BUT in stocks, we are the shareholders & we own part of the corporation (most of us are insignificant shareholders). Also shareholders are entitled to voting rights & profits of the firm, and as such are given dividend payments depending on the profitability of the company

For bondholder, they have a higher priority in claiming the assets than an ordinary shareholder. In case if any bankruptcies, a bondholder will get paid before shareholders. Although they do not entitled to dividends, they to get periodical coupon/ interest payments plus the principle amount
Types of bonds
I’m not that certain about the variation of bonds that exist in US market but generally there are 3 types. First is Treasury bill with maturity period of 1 year or less. Another is Treasury note with maturity 10 years or less & finally Treasury bond with maturity period up 30 years. This is what the US government often issued & the Japanese & Chinese government often take up

For corporate bonds which are riskier, are assessed by Moody’s & S&P. They will give a credit rating to these bonds. I’m sure you have seen somewhere signs like AAA, Aaa, CCC etc. Blue chip firms normally have higher ratings while risky firms may get poorer ratings. This will help investors to assess their risk appetite

How it works?
Interest rates & bond prices are inverse in relation. Say, if interest rates increase, bond prices will fall & vice versa. Why? Let me illustrate with figures (this is an over-simplification)

Bond with 10% coupon rate & at par value of $1000. Bondholders will get $100 every year (10% x $1000) which are paid semi-annually $50 & $50. But if the price goes down to $800, then its interest rates will be 12.5%. This happens because bondholders MUST GET the same guaranteed $100 ($800 x 12.5%). Conversely if bond goes up to $1200 the interest rates will drop to 8.33%

The ultimate return at the end the period is called YTM (yield to maturity) which equals to all the interest payments bondholders receive PLUS any gain (if bought at discount-below $1000) or loss (if bought at premium-above $1000)

Market force of demand & supply also play vital role in determining the price of bonds. In US, since there is no reliable form of investment at the moment, therefore most people throw their money into bonds. As demand for bond increase, therefore it pushes its price to higher level. As such this reduce its interest rate. Remember the interest rate & bond price works in different direction

Bonds also called as fixed-income securities typically because investors income are known & fixed (periodic payment of interest rate)

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