Investing in Bonds
What Are Bonds?
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due.
Among the types of bonds you can choose from in Uganda are: government securities and corporate bonds.
Many personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. Because bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and increase their capital or to receive dependable interest income. Whatever the purpose saving for your children’s college education or a new home, increasing retirement income or any of a number of other financial goals, investing in bonds can help you achieve your objectives.
Fixed-income securities present investors with a wide variety of choices to tailor investments to their individual financial objectives. Whatever your goals, your investment advisor can help explain the numerous investment options available to help you reach them, taking into account your income needs and tolerance for risk.
Key Bond Investment Considerations
There are a number of key variables to look at when investing in bonds: the bond's maturity, redemption features, credit quality, interest rate, price, yield and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your financial objectives.
Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Typically, investors receive interest payments semiannually. For example, a UShs 1,000,000 bond with an 8% interest rate will pay investors UShs 80,000 a year, in payments of UShs 40,000 every six months. When the bond matures, investors receive the full face amount of the bond? UShs 1,000,000.
But some sellers and buyers of debt securities prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating rate bond is reset periodically in line with changes in a base interest rate index, such as the rate on Treasury bills. Some bonds have no periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the purchase price (principal) plus the total interest earned, compounded semiannually at the (original) interest rate.
Known as zero coupon bonds, they are sold at a substantial discount from their face amount. For example, a bond with a face amount of UShs 2,000,000 maturing in 20 years might be purchased for about UShs 5,050,000. At the end of the 20 years, the investor will receive UShs 20,000,000. The difference between UShs 20,000,000 and UShs 5,050,000 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures. If the bond is taxable, the interest is taxed as it accrues, even though it is not paid to the investor before maturity or redemption.
A bond's maturity refers to the specific future date on which the investor's principal will be repaid. Bond maturities generally range from one day up to 30 years. In some cases, bonds have been issued for terms of up to 100 years. Maturity ranges are often categorized as follows:
Short-term notes: maturities of up to five years;
Intermediate notes/bonds: maturities of five to 12 years;
Long-term bonds: maturities of 12 or more years.
While the maturity period is a good guide as to how long the bond will be outstanding, certain bonds have structures that can substantially change the expected life of the investment.
For example, some bonds have redemption, or all provisions that allow or require the issuer to repay the investors principal at a specified date before maturity. Bonds are commonly called when prevailing interest rates have dropped significantly since the time the bonds were issued. Before you buy a bond, always ask if there is a call provision and, if there is, be sure to obtain the yield to call as well as the yield to maturity. Bonds with a redemption provision usually have a higher annual return to compensate for the risk that the bonds might be called early.
conversely, some bonds have puts, which allow the investor the option of requiring the issuer to repurchase the bonds at specified times prior to maturity. Investors typically exercise this option when they need cash for some purpose or when interest rates have risen since the bonds were issued. They can then reinvest the proceeds at a higher interest rate.
Principal Payments and Average Life
In addition, mortgage backed securities are typically priced and traded on the basis of their average life rather than their stated maturity. When mortgage rates decline, homeowners often prepay mortgages, which may result in an earlier than expected return of principal to an investor. This may reduce the average life of the investment. If mortgage rates rise, the reverse may be true, homeowners will be slow to prepay and investors may find their principal committed longer than expected.
Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment you are seeking within your risk tolerance. Some individuals might choose short term bonds for their comparative stability and safety, although their investment returns will typically be lower than would be the case with long term securities. Alternatively, investors seeking greater overall returns might be more interested in long term securities despite the fact that their value is more vulnerable to interest rate fluctuations and other market risks as well as credit risk.
Yield is the return you actually earn on the bond based on the price you paid and the interest payment you receive. There are basically two types of bond yields you should be aware of: current yield and yield to maturity or yield to call. Current yield is the annual return on the amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price. If you bought at UShs 1,000,000 and the interest rate is 8% (UShs 80,000), the current yield is 8% (UShs 80,000 ÷ UShs 1,000,000). If you bought at UShs 900,000 and the interest rate is 8% (UShs 80,000), the current yield is 8.89% (UShs 80,000 ÷ UShs 900,000).
Yield to maturity and yield to call, which are considered more meaningful, tell you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face, value) or loss (if you purchased it above its par value). Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive face value back at the call date. You should ask your investment advisor for the yield to maturity or yield to call on any bond you are considering purchasing. Buying a bond based only on current yield may not be sufficient, since it may not represent the bond's real value to your portfolio.
Market Fluctuations: The Link Between
Price and Yield from the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds' and true of the entire bond market with every change in the level of interest rates typically having an immediate, and predictable, effect on the prices of bonds.
When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher interest new issues.
When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.
Because of these fluctuations, you should be aware that the value of a bond will likely be higher or lower than its original face value if you sell it before it matures.
The Link Between Interest Rates and Maturity
Changes in interest rates don't affect all bonds equally. The longer it takes for a bond to mature, the greater the risk that prices will fluctuate along the way and that the fluctuations will be greater and the more the investors will expect to be compensated for taking the extra risk. There is a direct link between maturity and yield. It can best be seen by drawing a line between the yields available on like securities of different maturities, from shortest to longest. Such a line is called a yield curve.