Bonds Simplified

Companies can raise capital through a debt or equity raising. In the stock market we buy shares which are essentially equity in a company. Shareholders own a small portion of the company through their stock holdings. Equity investors hope to make a capital gain when they sell at a higher price than when they brought it. They may also receive dividend income from holding these shares. Bonds are debt instruments and are structured differently. In this article we simplify how bonds work.

What are bonds?

Organisations such as governments and corporations may want to raise money by issuing bonds. In a bond, an investor lends money to the organisation and they receive fixed regular interest payments before the bond matures. On the bond’s maturity date, the principle of the bond is repaid by the organisation.

How bonds are different to shares?

If a company or organisation becomes bankrupt, bond holders will have a higher claim of their capital whereas shareholders can lose all their investment. Bonds are stable investments but don’t provide as much capital appreciation as shares. The interest payments on bonds are fixed payments whereas shareholders are not guaranteed regular dividends. These dividends can also be stopped at any time the company decides to.

How do you make money trading in bonds?

Bondholders do not need to hold their bonds until maturity, they can sell it in the bond market for a capital gain. In a market when interest rates are falling new bonds which are issued will have a lower coupon than previous ones. This means that old bondholders who have higher coupon rates can sell it in market for a higher price. Bond traders can also use bonds to speculate. They may start buying bonds when they believe the economy is in a period when bond prices will appreciate.

What are convertible bonds?

A convertible bond is a form of a bond instrument that pays interest payments but is converted into ordinary shares at a particular date.

What are debentures?

Debentures are a form of debt instrument similar to a bond but is unsecured. The investor needs to depend on the organisation’s creditworthiness for repayment of debt. These instruments also pay regular payments called coupons and the principle is fully repaid on maturity date. As debentures are higher risk than bonds, they usually also pay higher interest.

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When are bonds popular?

Bonds are considered safe havens so when the economy is weak, investors tend to rotate out of riskier investments such as equities and put their funds into bonds.

How do bond yields affect the stock market?

Rising bond yields is bad news for the stock market as it means higher debt costs for companies and lower growth expectations from companies. Please see the following link for more information on this topic “Why rising bond yields is bad news for the stock market”.

Lauren Hua is a private client adviser at Fairmont Equities.

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