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Cultivate an Understanding of Bonds – Beginners Guide
Managing your wealth well is like tending a beautiful formal garden – you need to start with good soil and a good set of tools. Just as good soil has the proper fertility to nourish a plant, having the right foundation in financial literacy should empower you to potentially cultivate a successful investment portfolio. Cultivate an Understanding of Bonds is part of our financial education series to help educate you on the fundamentals of investing as you tend your very own financial garden.
What is a Bond?
If you are looking to build up a well-diversified portfolio, you will usually be advised to include both stocks and bonds among your investments. While stocks may offer you the potential for capital appreciation, bonds may provide a steady stream of investment income, and play an important role of potentially lowering your overall portfolio risks.
A bond is a debt security where the bond issuer (the borrower) issues the bond for purchase by the bondholder (the lender). It is also known as a fixed income security, as a bond usually gives the investor a regular or fixed return.
When you invest in a bond, you are essentially lending a sum of money to the bond issuer. In return, you are usually entitled to receive
interest payments (coupon) at scheduled intervals; and capital repayment of your initial principal amount at an agreed date in the future (maturity date).
Typical bond issuers include:
Non-bank financial institutions
How do Bonds Work?
Example of bond issuers and their funding needs
Cash for operating expenses
Capital for growth and expansion
Funds for corporate acquisitions
Cash for budgeted national expenditure
Funds for repayment of national debt
States, Cities, Townships
Cash for operating expenses
Funds to build public infrastructure
(for example, roads, housing, parks)
What Types of Bonds are there?
Bonds are differentiated by their varying payment features
The interest or coupon rate of the bond is fixed for the entire term (tenor) of the bond. If the bond comes with an embedded issuer call option, the bond issuer may prepay the bond at certain pre-determined dates.
Unlike Fixed-rate bonds, the coupon or interest rate of a Floating-rate bond is variable. The interest rate is reset at each coupon payment date, in accordance with a predetermined interest rate index. As in the case for Fixed-rate bonds, issuer call options may also be embedded.
This type of bond has a lower repayment priority than other bonds issued by the same issuer in the event of the liquidation or bankruptcy of the issuer. A subordinated bond has a lower credit rating because it carries higher risks but pays higher returns than other non-subordinated bonds of the same issuer. These bonds are usually issued by banks.
These bonds allow the bondholder and/or issuer to convert them into shares of common stocks/shares in the issuing corporation at a pre-determined price in the future when certain conversion criteria are fulfilled. Such bonds are usually issued by companies and tend to pay lower coupon rates than ordinary bonds of the issuer due to the attractiveness of the conversion feature.
TIPS (Treasury Inflation Protected Securities)
These bonds peg their principal amount to the inflation index, therefore protecting the bondholder against inflation. Such bonds are issued by governments.
Also known as a discount or deep discount bond, this bond is bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest or coupon payments, hence the term zero-coupon bond.
Why Invest in Bonds?
Higher returns than bank deposits
Bonds typically pay a higher yield (return) than bank deposits of a similar term (tenor).
Bond issuers are bound by the terms of the bond to pay out regular coupon income to bondholders (subject to credit risk of the issuer).
Hedge against inflation
With proper bond selection, you may potentially earn an investment return which keeps pace with or even exceed the inflation rate.
Like all instruments traded in the secondary market, the price of bonds can appreciate (or depreciate) over and above (or below) the initial purchase price, and allow you to realise capital gains (or capital losses).
What are the Risks?
Credit or Default risk
This is the risk that the bond issuer or borrower is unable to meet the coupon or principal payments on any outstanding bonds or debt (not just the bonds you may be holding) when they fall due (for example, due to bankruptcy or insolvency), and go into default.
Interest rate risk
Interest rates and bond prices are inversely related. Should interest rates rise, the price of your bond will tend to fall (and vice versa). The longer the time to maturity of a bond, the greater the interest rate risk.
Foreign Exchange risk
Some bonds are denominated (and the issuer’s payments made) in a foreign currency, which may fluctuate against your home currency. The impact of such foreign exchange movements may offset any interest or capital returns you may receive from the bond investment.
This is the risk of having to sell a bond at discounted prices due to the lack of a ready market or buyer. When a bond has a low credit rating (for example, due to the fact that it is part of a small issue or that the issuer’s financial situation is questionable), the liquidity risk will tend to be higher.
Events such as leveraged buyouts, mergers, or regulatory changes may adversely affect both (i) the bond issuer’s ability to make payments on the bond, and (ii) the price of the bond.
Payment of the bond may be affected by the political and economic events in the country of the issuer of the bond. For example, the issuer may be forced to make payments in the local currency of the issuer’s country instead of the original currency of the bond.
This article is for general information only and it does not constitute an offer, recommendation or solicitation of an offer to enter into any transaction or adopt any hedging, trading or investment strategy, in relation to any securities or other financial instruments. This article has not been prepared for any particular person or class of persons and does not constitute and should not be construed as investment advice or an investment recommendation. It has been prepared without regard to the specific investment objectives, financial situation or particular needs of any person or class of persons. You should seek advice from a licensed or an exempt financial adviser on the suitability of a product for you, taking into account these factors before making a commitment to purchase any product or invest in an investment. In the event that you choose not to seek advice from a licensed or an exempt financial adviser, you should carefully consider whether the product or service described herein is suitable for you.
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Country/Market Specific Disclosures
This document is being distributed in Kenya by, and is attributable to Standard Chartered Bank Kenya Limited. Investment Products and Services are distributed by Standard Chartered Investment Services Limited, a wholly owned subsidiary of Standard Chartered Bank Kenya Limited (Standard Chartered Bank/the Bank) that is licensed by the Capital Markets Authority as a Fund Manager. Standard Chartered Bank Kenya Limited is regulated by the Central Bank of Kenya.