Most bonds guarantee a stream of income throughout their life (as long as the issuer is financially sound). Fixed coupon payments could allow you to better forecast your returns compared to investments with variable returns, like shares. There are also zero-coupon bonds where everything depends on the repayment of principal at maturity.
Remember, bonds don’t all pay the same coupon!
As long as the bond issuer is financially sound, you’ll receive your principal back at the maturity of the bond. The maturity of a bond varies, ranging from 1 to 30 years, with some stretching out to Infinity and Beyond (known as perpetuals, or perps).
Bonds are a popular low-risk investment and for good reason. The fixed income and return of principal make them a less risky investment compared to other popular investments such as shares, REITs and commodities. A well-diversified portfolio should also incorporate investments at a similar risk level to bonds.
A bond’s issuer has to pay bondholders their coupons before they pay any dividends to shareholders. By law, bond issuers are obligated to pay bondholders before paying anything to shareholders if they get into financial trouble. This is known as being "higher up the capital structure", and explains why returns, with lower risks, are typically lower for bonds than for the equivalent shares.
There's no guarantee that a regular bond’s coupon will match or beat inflation. For example, in December 2022, US Government 10Y bond yields (3.6%) were below levels of inflation (7.1%), meaning that investors were worsening their purchasing power in buying them.
However, there are also inflation-indexed bonds, like the Treasury inflation-protected securities (or TIPS) in the US, where the interest rate is fixed but the coupon and face value adjust along with some measure of inflation, usually the CPI.
There is a chance, albeit usually a very slim one, of a bond issuer getting into financial trouble and being unable to pay out a coupon or principal on maturity. The price of a bond reflects the credit quality or likelihood of default of the issuer. Default risk is much higher with junk or high-yield bonds compared to investment-grade bonds.
If you find yourself in a position where you sell your bond before maturity, you could receive a sum lower than the face value, and lower than the price you originally paid. It just depends on demand and supply for that particular bond at the time (and the bid price your broker is willing to quote you).
There is an inverse relationship between interest rates and bond prices, meaning an increase in interest rates will lower bond prices. (The coupon is fixed, so for a higher interest rate, the bond price would have to be lower.) The longer the term of your bond, the more exposed you are to interest rate changes during the bond's life.
Government bonds are easy to sell, but corporate bonds can be a little tricky since they usually get priced off-market by banks/brokers. These banks/brokers hold the bond in "inventory" and are willing to "make a market", meaning they offer both a buying and selling price at the same time for a certain number of bonds, with a "spread" between them. The relatively small size of the market and some lack of transparency also means that bond prices can be volatile.
Bid-Ask Spread
There may be two prices given for any financial instrument. One is the bid price and one is the ask price. The bid price is the price at which you sell the financial asset to the broker, while the ask price is the price at which you buy the financial asset from the broker. The bid price is typically lower than the ask price, which is how the brokerages’ profit!
The bid-ask spread is defined as the difference between the bid price and the ask price. You can think of this as the price the brokerage charges you to trade that financial asset. The bid-ask spread will vary from brokerage to brokerage and from bond to bond, so keep this in mind!
Some bonds, such as perpetual securities (explained further above), have an early redemption call feature. If the issuer exercises its right to redeem, then you will get the face value paid out and may find yourself sitting on cash and unable to purchase a new bond with as high a coupon or yield, meaning your expected returns decrease.
ADVANTAGES AND DISADVANTAGES OF BONDS. COMPLETED. ✅
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