Bond Basics
One of the challenges to individuals trying to understand financial matters is that multiple terms are used for the same things. For example, we often hear the words bonds, treasury notes, debentures and, by and large, these refer to the same type of investment.
At its most basic level a bond is a loan to a government or corporation. From the investor’s perspective the bond functions as an ‘IOU’ from the borrower in which the lender is promised a full refund of their investment after a fixed period of time and is compensated for by receiving a fixed rate of interest until that time.
When it comes to the interest rate on a bond risk is the factor which plays the biggest role. The first factor which must be considered is logically the credit worthiness of the lender. Logically, if the lender has a good credit history you are likely to be more at ease than with one who is or has a history of financial distress. As a result, additional compensation for this risk is built into the calculation of the bond’s interest rate.
Traditionally, government debt is considered the lowest risk since in theory, when a government needs more money in its local currency, they can simply print more money or raise taxes. It should be noted, however, that these measures obviously create other issues in the economy, for example increased inflation and even with these facilities at their disposal some government bonds have had to default.
On the other side of the coin would be corporate bonds. As you would expect there is a wide spectrum between the quality of various bond issues and again the riskier the issuer the higher the coupon. Ratings agencies such as Standard & Poor, Moody’s, Fitch on the international market or regionally CariCris assist investors in assessing the creditworthiness of an issue by providing ratings.
The length of time to maturity is another factor which impacts the coupon rate of the bond. Typically, the longer the time before the maturity of the bond the greater the risk, firstly of default of the lender and secondly the greater the likelihood that the value of the bond would be affected by a change in the interest rate. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most in value when rates fall.
We hope you’ve enjoyed this article. Feel free to give us a call at 434-2363 to discuss how our experienced brokers can assist you with reaching your investment goals today.