Investing in Bonds- Excerpts of the book “Finance for Dad”

What is a bond?

This expression refers to a security that supports a debt. When a person invests in bonds, he/she is lending money to the government or a corporation for a specific period. As compensation, he/she will receive interest returns periodically. When it expires, they will give back the value for which it was issued. This is known as face value or par value. These instruments are usually purchased by people who need a permanent fixed income, or those who require the principal at a specific period.

Even though these instruments are eminent income generators, they can also make capital gains if their prices go up and the owner sells them at that moment. There is a vast diversity of securities which can be classified as such

A.   Issuer. Governments or government-linked entities (states, municipalities and government agencies) are the regular issuers of public bonds or treasury bonds, and corporations or private companies issue corporate bonds.

B.    Expiration date. It is called the maturity date in the financial jargon. It is the future date on which the issuer will pay the principal to the investor or creditor. Maturities can range from as little as several days to as long as 100 years.So, bonds with short maturity produce a low return, whereas long term should produce a higher return.

C.   Risk. The strength of the issuing entity is the most important factor to consider. Government bonds (issued in local currency) are far more secure than those issued by any corporation. The reason behind this is that governments always have the power to “create” as much money as they require paying their debts. Corporations, on the other hand, depend upon their ability to generate profits.

A very useful tool for evaluating bonds, before investing, are the qualifications assigned by the credit rating agencies (Moody's, Standard & Poor's, Fitch Ratings and others). Those bonds included in the “AAA” or “Aaa” lists hold low risk, which consequently also have low return. On the opposite side, we can find high risk and high return bonds, also known as junk bonds. They are rated as C and D. As a general rule it is advisable to limit the investments to low and medium grade bonds, which are those of medium to low risk, issued by leading companies and ranked between BB and AAA.