Bonds are an attractive investment assets and are appealing for any investor because of fixed interest income option which is not available in stocks. Furthermore, certain bonds as Treasury and Federal Agency bonds also offers tax advantages to the investor. Thus, such distinctive feature makes bonds an appealing investment class.
Some of the bonds which are currently available are:
- Treasury Bonds
- Agency Bonds
- Municipal Bonds
- Corporate Bonds
Below are some common investment objectives that can be fulfilled through investment in Bonds:
i) Fixed Income Security:
Since bonds are fixed income securities, they are known to offer a certain interest income depending on the type of bond purchased by the investor. This feature is not available in stocks.
ii) Tax Advantages:
Many bonds issued by Federal Agencies offers tax advantages. For Instance Treasury and Federal Agency bonds offers tax advantages while municipal bonds offer tax shelters for the investors.
iii) Capital Appreciation:
Apart from offering a fixed current income to a conservative investor, bonds can also used by
investors who prefer capital gains that arise from swings in interest rates.
Below discussed are some of the risk associated with investment in bonds:
1)Interest Rate Risk:
It refers to the effect of changes in the prevailing market rate of interest on the bond value. When interest rate rises, bond value falls.
2)Exchange Rate Risk:
This source of risk arises from the uncertainty about the value of foreign currency cash flows to an investor in terms of his home country currency. For Instance, a US Treasury Bill may be risk free for an American Investor but not for a European or other global investor as the value of a T-Bill will be reduced by a depreciation of US Dollar relative to their home currency.
This refers to the fact that when market rates falls, the cash flows from bonds must be reinvested at lower rates, reducing the returns an investor will earn.
Call risk arises from the fact that when interest rates fall, a callable bond investor’s principal will be returned and must be reinvested at lower rates.
ii) Yes, call features may result in the early exercise of bonds with relatively high coupon payment streams. Since call provision give the issuer the right to retire all or part of an issue prior to maturity, it gives the issuer the opportunity to replace the higher than market coupon bonds with lower coupon issues.
Both interest rates and bond value carry an inverse relationship. In other words, as the interest rate falls , the value of bond increases and vice-versa. For Instance, if US treasury issues bonds at prevailing market interest rate of 8% and with face value of $1000, in such case, the bond will pay coupon of $80.
However, if the market interest rate rise to 10%, then no one will buy the bond till the value of bond is reduced. So, with increase in interest rate, bond value falls at a level where the fixed $80 annual payment were the equivalent of a 10% annual yield. In this example, the price will decrease to $800 so at 10% annual yield, the return Is $80 . Conversely, if market interest rates were to fall to 6%, the price of the bond would rise.
Some of the primary determinants of market interest rate includes:
- Demand and Supply of Loanable Funds
- Prevailing Economic Cycle
The value of a bond is dependent on relationship between market yield and coupon rate. When issued, the coupon rate on bond will be typically set at or near the prevailing market yield on similar bonds so that the bonds trade initially at or near their par value.
However, if the yield required in the market for the bond subsequently rises, the price of the bond will fall and it will trade at a discount to its par value. Conversely, if the required yield falls, the bond price will increase and the bond will trade at a premium to its par value.
Yes, both yields and returns(coupons) are effective as they determine true value of bond on the basis of existing market rates.
CFA Institute. (2011). Fixed Income Securities. Boston: Custom.