The Woo Group RBC Wealth Management Hong Kong USA: Bond Basics
Often considered to be one of the most conservative of all investments, bonds actually provide benefits to both conservative and more aggressive investors alike. The variety of bonds available provides an array of options to meet many investment goals, from earning regular income to achieving capital appreciation much like stocks. To understand these benefits, it is important to understand how bonds work. This fact sheet explains the fundamentals of bonds, addressing: how bonds are structured and priced; what factors affect prices; how to measure return; types of bonds; bond risks; and bond taxation. By learning about these bond basics, you’ll be on your way to understanding how bonds can contribute to your investment goals.
In the financial world, there are fundamentally two types of security investments: debt and equity. Issuing debt (bonds) is an important way for different types of issuers to raise money to fund projects or build capital. The most common bond issuers include: federal governments, federal agencies, municipalities, and corporations. While all of these entities can issue debt (bonds), only a corporation can issue equity (stock).
One of the key ways in which bonds differ from stock relates to the issuer’s obligation to the investor. When an investor buys stock in a corporation, that investor becomes a partial owner. The stock offers the possibility of capital appreciation and dividend payments to the stockholder, with no guarantee that either of these will occur.
A bond, on the other hand, makes a promise of return to the bondholder. The issuer agrees to pay the bondholder a fixed interest payment on a regular basis until the bond’s maturity, at which point the issuer will pay the original face value of the bond. A bond certificate, in essence, is simply a promissory note or “IOU”, which legally binds the issuer to repay the amount paid per the IOU and describes the terms of the loan. As a creditor of the issuer, the bondholder has a senior claim on the liquidation of assets over stockholders if the issuer were to file bankruptcy.
Bonds, in the most generic sense, are issued with three essential components.
Maturity — Maturity indicates the life of the bond. Most bonds have maturities ranging from 3 months to 30 years.
Par Value — Par value, also called face value, is the amount the bondholder will be repaid when the bond reaches maturity. For instance, if you purchase a $1,000 par value bond, you will receive $1,000 at maturity
Coupon Rate — Coupon rate (also referred to as interest rate) is the percentage of par value that will be paid to bondholders on a regular basis. For example, if you purchase a $1,000 par value bond with a 10% coupon rate you will receive $100 interest each year.
Characterized by fixed interest payments and a return of principal at maturity, bonds are commonly referred to as fixed income securities.
Why Buy Bonds?
Investors purchase bonds to take advantage of their many benefits compared to alternative investments.
Safety/Capital Preservation — Because the bond issuer must pay back the bond’s face value at maturity, an investor’s original principal is preserved, unlike stock where the investor can lose the original investment value. The degree of safety varies with bonds of different types and ratings.
Fixed Return — Investors receive fixed, regular interest payments which provide an element of predictability versus common stocks where the returns are less certain.
Current Income — For those wanting a regular cash income, bonds provide regular interest payments at set times.
Reduce Portfolio Risk — Due to their more certain nature compared to equities and their divergent behavior in tumultuous markets, bonds are a great way to reduce the risk in an investment portfolio.
Capital Appreciation — Many investors benefit from trading bonds in the secondary market to take advantage of price increases, much the same way as they would trade stocks.