Understanding Bonds – Beginners’ Guide

I assume you are familiar with borrowing money from family members, friends, cooperative societies, banks, etc. In borrowing these funds, you either promise your friends with words of mouth or a collateral in the case of a bank. This is similar to how a bond works. 

A bond is an instrument used by governments or corporate firms to raise money from investors. The party who issues the bond is the bond issuer while the buyer is the bondholder. The bond serves as a promise for the bond issuer to pay back the principal with interest over a certain period. In the case of a bond, the interest is mostly fixed and predetermined. The interest is usually referred to as coupon. Typically, coupons are paid semi-annually. Also, the bond issuer will specify how long it will take to repay the investors (maturity date). For context, a company may be willing to borrow a specified amount for 10 years with a promise to pay a coupon of 10% annually. In a case you invest N500,000 in the bond, it means you will receive N25,000 semi-annually (10% of N500,000 divided by 2). 

The first way to make money from investing in bonds is what I just explained, i.e., to hold the instrument till the maturity date. This allows you to collect the coupon payments as well as your principal at maturity. However, there is another way to make money from bonds without waiting till maturity, which is to sell the instrument before the maturity date. In this case, you cease to earn coupon on the bond as soon as you sell off the instrument. For instance, if you buy N500,000 worth of bond and you sell it when the market value of the bond is N520,000. You make a capital gain of N20,000. 

There are two major reasons why bond prices could rise or fall. Firstly, the bond issuer’s credit rating can be a factor. There are credit agencies who rate both the instruments and the issuers to ascertain their credit quality. Therefore, the price of a bond can rise if the issuer’s credit quality improves as this could spur demand for the instrument, and vice versa. Secondly, the bond’s prevailing interest rate is an important factor. While the interest rate promised by the borrower at the issuance date is called the coupon rate, the prevailing interest rate on the instrument in the market is referred to as the yield. The bond yield and price have an inverse relationship. If the yield goes up, the price goes down and vice versa.

Investing in bonds has its pros and cons, as every other investment. Some of the pros are capital preservation, low risk, fixed income, portfolio diversification, and risk management. Some of the cons are lower interest rate compared to more risky investments, its value being linked to the issuer’s creditworthiness, etc. 

As we advised in our article on guiding principles for investment decisions, it is necessary to tick the necessary boxes before making your decision on whether to invest in a bond or not. 

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Thank you for reading and look out for our next article!

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