A bond is a type of loan that large companies use to generate income. As an investor, you lend a company money by purchasing a bond. In exchange for that money, the company will pay interest to you. It will have a maturity date, which will end the loan and return the initial principal to you. In this article, we will go over what to look for when considering a bond, the risks, and ratings.
Every bond has different features which will affect your gains. So it is important that you understand these features before you purchase one. There are six main features you need to consider when looking for a bond.
- Maturity: This is the date when the bond’s principal is paid back to you as the investor and the obligation comes to an end.
- Secured/Unsecured: There are two types of guarantees that come with a bond. Unsecured bonds are guaranteed only by the credit of the issuing company. With a secured bond the company pledges specific assets to repay bondholders in the case of default.
- Liquidation Preference: If a company goes into bankruptcy, there is a specific payback order. Which type of investment you choose will have an effect on whether or not you receive your investment back in case of default.
- Coupon: Coupon refers to the amount of interest paid to the bondholder. Companies pay interest annually or semiannually.
- Tax Status: Bonds have different tax status’. Most corporate bonds are taxable. There are government and municipal bonds that are tax-exempt. However, these types of bonds tend to have lower coupons.
- Callability: If a bond has a call provision it means that the issuing company can pay it off before the maturity date.
Before you purchase any type of investment it is important that you consider the risks. Bonds do carry some risks. These include:
- Default Risk: This is the risk that a company will not be able to pay back its investors after they default.
- Prepayment Risk: This is the risk that a bond with a call provision will be paid off early. This puts you at the risk of having to give up high interest bonds in a low interest rate environment.
- Interest Rate Risk: This is the risk that you get stuck with a bond that has a significantly lower rate than the current market. The longer the maturity period is, the greater the interest rate risk increases.
Standard & Poor’s and Moody’s & Fitch are the most trusted well-known bond rating agencies. These companies rate bond issuing companies so that you know if a company can repay its obligations. AAA to Aaa bonds have the highest rating and the most likely to receive repayment. A BBB to a Baa rated investment means it is unlikely to default and is a stable investment. BB to Ba is a very poor rating, known as junk bonds. It is important to check the ratings of any bonds you are considering purchasing so you can ensure you are getting a quality investment.
If you are considering investing in bonds, these are just a few of the things you should keep in mind. It is important to meet with a qualified investment manager before making any investment decisions.
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