In this post, we are going to discuss the question of how do bonds work. It is my sincere hope that once you read this post you may consider taking part in the bond market.
In most cases purchasing a bond is a much better option than putting your money in a savings account. A bond offers a better return for your excess cash.
I however appreciate the fact that for most people, the issue of bonds is like Greek to them. Unless of course if you are heavily involved in the financial markets or is a finance professional. I will, therefore, start by explaining what bonds are.
I hope that doing that will make it easier for readers to understand how bonds work. One cannot understand how bonds work until he understands what bonds are.
So what is a bond and how do bonds work?
In simple terms, a bond is an IOU to a company or the government. Companies or governments issue bonds to raise funds from the financial markets.
In other words, when you buy a bond you are simply lending money to an organization or company.
In return, the organization commits to pay back the face value of the bond or loan at a specified date. In the meantime, the lender will be receiving interest usually at the end of each year of the period for this lending.
The interest rate that is used is determined before everything is finalized. It is called the coupon.
For example, if a company issues a 10-year bond for $10,000 at a coupon rate of 10%, then $10,000 is the face value of the bond and 10% is the interest rate you will get usually at the end of each year.
Face value is the amount the bondholder will be paid at the maturing of the bond i.e. the end of the period of the bond. In the example above, the maturity date is at the end of the ten years and the face value is $10,000.
Let me try to break down the example for you in simple terms. The issuer of the bond, in this case, is saying that in 10 years’ time I owe you $10,000 and in the meantime, I will be paying you interest of 10 percent of the $10,000 i.e. $1,000 for the next 10 years.
In most cases, bonds bought on the secondary market fluctuate in value over the course of the period of the bond. While the face value, usually the amount you paid to purchase it, remains constant its market value fluctuates depending on market conditions.
What Happens If the Market Value of The Bond Falls?
For most bonds, the rate of interest rises if the market value goes down.
This means that if you purchased a bond for $10,000 at a coupon rate of 10% and the market value falls to $9,000 then the new rate of interest will be 10/90×100=11.1%.
The 11.1% is the rate that will be applied to the new market value of $9,000 to determine the amount to be paid to you.
If however, the market value rises the rate of interest will go down. For example, if in the example above the market value rose to $15,000 then the rate of interest will now be 6.6% (10/150×100).
Can You Lose Money in the Bond Market?
The ability to get your money back is of course dependent on the issuer not defaulting. Bonds are like any loan and carry with it risks of default too.
There is always a risk that you can purchase a bond from a company that is about to fall. These bonds are called junk bonds.
A few years ago, during the financial crisis, it was discovered that ordinary citizens had bought junk bonds issued by financially troubled institutions. Many ordinary citizens lost their life savings as a result.
These innocent citizens trusted the financial organizations selling these bonds on the secondary not knowing that the real owners were troubled organizations and companies.
If you are therefore just starting out in the bond market I would encourage you to first buy government bonds as they are more or less foolproof. The government can essentially print money to pay off its debts.
I would for instance trust western governments when it comes to bonds. They essentially control the world economy.
As for the other countries you need to do proper due diligence as most bonds are denominated in US dollars and some of these countries may have limited dollar-denominated foreign reserves.
There have been cases recently when governments in South America defaulted on loan repayments. The maxim, Caveat Emptor (Buyer Beware) is in order here.
One good thing about bonds is that the bondholder is free to sell it on. The only restriction being that that should take place before the end of the agreed time.