Investing in bonds is an excellent way to protect your wealth and help you build a comfortable nest egg. However, you should have a firm grasp of how bonds work before investing in this lesser-known security. So, what are bonds exactly? Read on to discover our simple guide to understanding bonds as investments! 

What Are Bonds: Definition

Bonds are certificates of debts issued by companies to investors who purchase them. Similar to stocks, bonds are also securitized as tradable assets. 

However, unlike stocks, you are not seeking to own a piece of a company when you invest in this type of security. Instead, bonds offer investors returns through interest paid based on the principle of the bond. 

Sometimes, companies, municipalities, states, or governments need to raise a large sum of money to finance projects and operations. They may choose to “borrow” the sum needed through the selling of bonds. 

What Are Bonds: How Do They Work

Bonds are inherently debt securities. In other words, owners who invest in bonds are entitled to a stream of interest payments. This unique characteristic makes bonds a low-risk investment. 

When you purchase bonds, you are essentially lending money to the issuer, who will pay you regular interest. Eventually, the bond will mature and the principal amount will be returned to you. 

The regular amount paid to the investor is called the coupon rate. For example, imagine you have a $10,000 bond that will mature in 10 years with a coupon rate of 5%. 

You will receive $500 per annum for the next 10 years, and the original face value of $10,000 will be paid back to you. 

Some people choose to sell their bonds and manage to gain a profit from them. Of course, the value of the bond needs to appreciate to a value that is higher than what you paid initially. 

What Are Bonds: Risks of Bonds

Although bonds are relatively safer investments compared to other securities like stocks, they are not entirely risk-free. 

• Credit Risk

If you invest in bonds, you may be subjected to credit risk. This is when the bond issuer defaults on its debt obligations.

• Liquidity Risk

Another risk is liquidity risk, where the issuer is not able to meet its short-term financial demands. 

• Interest-Rate Risk

You may also encounter the interest-rate risk, which may reduce or boost the bond’s market value. 

What Are Bonds: Understanding Bond Trading

Investors may choose to exchange bonds among themselves in bond trading. The goal is to identify bonds that will increase in value. 

Below are two main factors that bond traders will look out for to find bonds that will increase in value and result in capital gains.

• Declining Interest Rates

As interest rates decline, the price of issued bonds will rise. The opposite is also true because older bonds pay more than newer ones. However, when interest rates increase, older bonds will decrease in value since newer ones now pay more. 

• How “Safe” the Issuing Company is

Naturally, high-risk companies would also affect investors. Therefore, the value of bonds will increase if investors think the business is less risky. 

What Are Bonds: Why Invest in Them

Contrary to popular belief, bonds are neither just for the wealthy nor the over-conservative investor. 

They are an essential ingredient for anyone who desires a well-diversified portfolio. Why is this important? Let us explain.

You’ve probably heard of the advice: don’t put all your eggs in one basket. The principle applies here, since focusing on only one type of investment over a long period of time can be risky. 

Wise investors would diversify their portfolios (divide their eggs into different baskets) and balance them with high, medium, and low-risk investment products. This way, they can reap significant returns with relatively lower risk. 

Furthermore, they would have a buffer against the highly volatile stock market. Not to mention, investing in bonds may just give you the boost you need to achieve your financial goals. 

So, are you ready to diversify your portfolio? Besides bonds, forex is also a popular approach to diversification for investors. Check out our FREE eBook on Forex! We’re sure you’ll find it incredibly useful in helping you master the basics of forex trading. 

If you’d like, you are also welcome to join Just2Trade’s Forex Academy, where you’ll be coached by inspiring veterans in the forex market and more. Register to start trading like a pro today!