So little is written about bonds. However, with the attractive returns that bonds yield now, it is time to bring the spotlight on bonds. Here we discuss the nuances of this asset class.
What are bonds?
Bonds are a type of investment in which an investor loans money to an entity (typically a corporation or government) in exchange for interest payments and the return of principal at maturity. Bonds are considered to be less risky than stocks but typically offer a lower return. Investors often use them to preserve capital and generate income, and companies and governments to raise funds for operations and projects.
Bonds are a type of fixed-income investment that pays periodic interest to the bondholder, known as the coupon rate. The return on a bond is determined by the coupon rate, the price at which the bond is purchased, and any changes in interest rates. The price of existing bonds fall when interest rates rise, and the bond's yield is higher. Conversely, the price of existing bonds rises when interest rates fall, and the bond's yield is lower. In addition to the coupon payments, the bondholder will receive the face value (or "principal") of the bond when it matures.
Factors affecting bond yield:
Bond yield is the return an investor receives from a bond, typically expressed as a percentage of the bond's price. Factors that can affect bond yield include interest rates, credit risk, inflation, and market conditions.
Interest rates:
Bond prices fall, and yields increase when interest rates rise. When interest rates fall, bond prices rise, and yields decrease.
Credit risk:
The risk that the issuer of a bond will default on its payment obligations. Bonds with higher credit risk will typically have higher yields to compensate investors for the added risk.
Inflation:
Inflation can erode the purchasing power of a bond's fixed interest payments. To compensate for this, bonds will have higher yields in higher inflationary environments.
Market conditions:
Factors such as supply and demand in the bond market can also affect bond yields. When demand for bonds is high, bond prices will rise, yields will fall, and vice versa.
Overall, all these factors affect the bond yield, and the bond yield and price move inversely means that as a bond price increases, bond yield decreases, and bond yield increases as a bond price decreases.
When should you opt for short-term bonds?
Short-term bonds are similar to money market securities. They are debt securities that typically mature in less than one year. These bonds are considered less risky than long-term bonds because they are less affected by interest rate changes and have a shorter time to maturity. Short-term bonds are often used by investors looking for a safe place to park their money for a short period of time or as a way to manage cash flow.
Bonds having short maturity tenure are often more resistant to interest rate changes than other asset classes. Purchasing a bond and keeping it until it matures entitles you to the specified principle and interest rates.
Compared to money market funds, bonds are riskier. The bond may be paid off early with the remaining interest payments forfeited, or the bond's lender may default on principal and / or interest payments. The bond may be called, paid off, and reissued at a reduced rate if interest rates decline, costing the bond owner money. If interest rates rise, the bondholder may experience opportunity cost losses as a result of keeping their money in the bond rather than investing it elsewhere.
When should you opt for long-term bonds?
Long-term bonds have a maturity date of more than 3-5 years in the future. They typically offer higher yields than shorter-term bonds but also carry more risk because they are affected by changes in interest rates over a longer period of time.
Long-term bonds are more sensitive to interest rate changes than short-term bonds. This is because the value of a bond is inversely related to interest rates, so when interest rates go up, the value of the bond goes down, and vice versa. As the time to maturity of a bond increases, the bond's sensitivity to changes in interest rates also increases. They run the interest rate, credit or default risk, inflation risk, liquidity, and currency risk just like short-term bonds. However, given their duration, they are likely to be more sensitive towards them.
Investing in long-term bonds can provide a reliable source of income through regular coupon payments and the potential for capital appreciation when the bond is sold before maturity. Long-term bonds with high coupon rate offer a lower level of interest rate risk compared to long term bonds with low coupon rate that have high interest rate risk. Additionally, they may serve as a form of diversification within a portfolio, as their performance tends to have a low correlation with stocks. When the bond yields are good, you should lock in the yield over the long haul.
To wrap it up:
Understanding the nuances of bonds and their suitability, we should consciously gain appropriate exposure to this asset class for risk reduction and desired diversification. For assistance, you can always reach out to the experts at the Tata Capital Wealth team for further information.
14 February 2023
5 mins read
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