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Investment BondBonds are viewed as an obsolete form of investment among todays investors who want a high and instant return on their investment. In the search for instant riches, people are playing with huge sums of money in the stock market. However the market is unpredictable and a dull market can cost you a fortune. It is better to invest a part of your savings in bonds that offer a guaranteed return on your investments. Depending on your risk taking ability you can allocate a section of your funds to bonds. Investing in shares gives you voting rights and a share in the future profits of the company. Investing in bonds just gets you a fixed return on your investment. However equity does not result in a fixed return and is a risky proposition.
Before investing in bonds you must be familiar with the types of bonds and other terms associated with them. A bond is a savings instrument issued by the federal or state governments with a high and assured rate of interest. Government bodies constantly need money for different projects and finance some of their requirements by issuing bonds to retail investors. So a bond is a saving instrument issued at a specific interest rate for a specific period of time. Bonds are popular since they offer the highest safety as they invest in debt instruments and are issued by the government.
Bonds are issued for a fixed period and the investor gets a fixed interest every year till maturity. Most bonds pay interest twice a year and return your principal amount at maturity. The interest rate may be fixed or floating. A floating rate bond bases its interest rates on an index and can vary during the life of the bond. The face value of the bond is its issue price. There is a market for bonds and the bond may sell at a discount or a premium depending on the demand and the market conditions. Bonds can have maturities ranging from a few days to thirty years, with a higher interest rate on the longer tenure bonds. But a longer tenure bond will face more fluctuations in the interest rates then a short-term bond.
As a retail investor you assume that you will hold the bond till maturity, but you can also sell the bond at a higher rate in the bond market at prices that fluctuate daily. You can sell the bond depending on the yield. The yield is the amount of interest you get when the price of the bond changes. Now if the price falls, the yield increases and the yield falls if the price of the bond increases. As a buyer you will buy when the prices falls and get a higher yield, while as a seller you will want the price to increase.
The interest rates in the market also determine the price of the bond. An increase in interest rates causes the price of the bond to fall, and increases the yield on the bond. In this case the older bond becomes at par with newer bonds issued at higher interest rates. Similarly when the interest rate falls, the price increases and the yield declines. This brings the interest rate at the same level as new bonds issued at lower interest rates. So understand these inter-relationships before you decide to sell your bonds.
Let us now understand the types of bonds available in the market before investing in them. Government bonds mature after ten years and offer the highest safety. Municipal bonds come next and offer good returns to local residents, as they are exempt from federal tax. Some authorities exempt them from local taxes, making them totally tax-free.
You can invest in corporate bonds issued by companies for periods ranging from five years to long-term bonds of more than twelve years. The interest rates are considerably higher than government bonds as the risk of a company defaulting is also higher.
As a vigilant investor you must invest only in the corporate bonds of reputed companies with a good track record. Most company bonds are debentures not secured by collateral. So you face a dual risk of interest rates as well as of your principal. Therefore study the consequences of a default and a change in interest rates before investing in risky corporate bonds. Corporate bonds can be callable after a certain period or they can be convertible into company stock after a period of time. You can invest in zero coupon bonds that are issued at a discount and make the interest payments at maturity. But stay away from high risk promising bonds that are junk bonds issued by dubious companies.
The bond certificate carries the name of the issuer and the rate of return. It mentions the date of maturity and the call date if it is a callable. The bond carries the principal amount and the issue price that may be different from the face value of the bond. You can purchase bonds through a bond broker or directly from the government. The broker may give you some commission on your purchase, but he may require you to make a deposit for transactions made through his brokerage. If you cannot afford this you can invest in a mutual fund specializing in bonds.
Before you buy bonds assess the risk by studying the credit rating issued by rating agencies. These agencies study the company on various parameters and determine its debt-repayment ability. The two main parameters are interest coverage and capitalization ratios. Interest coverage implies whether the company can generate enough income to payoff the interest on its debt. The capitalization ratio assesses the financial leverage of the company on its assets. A lower capitalization ratio implies the company has a strong financial leverage.
Other risks include the call risk for a callable bond and an event risk implying a natural disaster or changes in financial regulations that can affect the bond rating. Remember to diversify your portfolio by investing a substantial sum in bonds. But devote enough time to research the bonds before you make your investment.
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