Friday, July 01, 2011

Introduction to Bonds

A bond is a fixed income security which gives you a predetermined return for a specified number of years. At the end of this period (on maturity date), you get your full investment back.
In simple terms, a bond holder is a lender who has loaned funds to the issuer of the bond. Bonds are normally issued by companies or governments when they are in need for a large amount of funds. The borrowing company or the government makes a promise to pay back the borrowed amount on a specific date and also pays a periodic interest to the lender in return for the use of funds.

Why are Bonds Issued?

Companies often need new funds to facilitate expansion plans or for other large expenses. Some times these funds cannot be accessed from banks because of the sheer magnitude of the amount required. The government is also frequently in need of money to fund large projects like infrastructure or aid programs. When this kind of need arises, an organization can resort to making a bond issue to raise funds from the general public. When millions of people provide a certain amount as loan to the issuer, massive funding needs can be easily met.
Why People Invest in Bonds?
Bonds provide stability to your investment portfolio. Smart investors always seek to balance the volatility of the stocks in their portfolio with a few well chosen bonds. This lends more consistency to
their returns and keeps their entire portfolio from being wiped out whenever the stock market does badly. Investing only in stocks is not a sensible approach to investment.
Putting all your eggs in one basket in this way concentrates the risk and leaves you with no alternative investments which can bear the brunt of a stock market crash. Having the right mix of bonds along with stocks is an important tenet of portfolio diversification and it has proven its worth time and again.

Bonds vs. Stocks
A good way to understand bonds is to compare them with stocks, the more well-known investment option:
These are debts which the bond issuer owes to you.These are equity investments, giving you a share of a company.
Bonds don’t give you any ownership so you don’t get any right to participate in the issuer’s decision making processes.The ownership grants you voting rights in the company and you can contribute to major decisions.
Guaranteed returns at predetermined intervals and an assured face value repayment on maturity, unless the issuer defaults.Highly volatile investments which give no assurances about the returns you gain.
Bond holders, as lenders, get priority payback in case of bankruptcy.Stockholders, as part owners, get the last priority in terms of payback when the company goes bankrupt .
The debt holder does not get a share in the profits of the company directly through the bond but he is entitled to assured interest paybacks.Profit sharing makes these highly popular because of the spectacular returns they can generate.
The differences between stocks and bonds make it very clear that both have their own advantages and disadvantages, and both are important parts of a balanced portfolio. The true importance of bonds becomes evident when stock prices take a nosedive.
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