A bond is a loan issued by a government or company. Bonds are basically debt instruments where the borrower agrees on a certain interest rate beforehand, which it pays to the loaning party or parties. Bonds have their share of risks, as do all financial instruments.
When are bonds useful?
Bonds are mostly bought by traders to increase the stability of their portfolio; bonds are much less risky than stocks. Only when the issuer of a bond goes bankrupt there is the possibility that you will lose your money. Generally speaking, you will always receive the agreed-upon interest.
A huge downside of trading stocks is the lack of certainty. The prices can go up and down in a heartbeat. It’s recommended that you spread the risk as much as possible. By buying bonds you can compensate for any potential losses from decreasing stock prices.
Keep an eye on the risk
Just like with stock, every bond carries a certain risk. The risk depends on the solvency of the government or company issuing the bond and it is important to check whether or not the government or company has financial problems or not. The biggest risk of trading bonds is that due to bankruptcy you lose all your money at the end of the duration.
Normally governments are more solvent than companies. In the recent economic crisis it has come to the surface that some governments can’t pay back bonds; a good example is the Greek government.
Risk and return
The biggest risk of trading bonds is not getting back the money you put in. Risk and return are always connected; the higher the risk of a bond the higher its interest will also be. Traders are only interested in putting up the money if they receive a high enough reward to be willing to risk it.
When you buy bonds, you can use the report figures of the solvency issued by agencies such as Standard & Poor’s, Moody’s and Fitch. A triple A status is the most secure and a triple D status is the most insecure. On the website of Standard & Poor’s, you can see current reviews for companies and governments.
In the article ‘Trading bonds’, we look at the most important features of a bond, how the price is determined and the relation between market interest and the price of a bond.