A Dutch East India Company Bond issued in the 17th Century
Understanding investment and speculation is, unfortunately, more difficult than most people seem to think. Moreover, deciding on the correct type of investment is a more complex task than choosing between coffee machines or iPad covers. Neither of the latter carry the risk that speculation does. Bonds are a type of investment that are generally considered to be of a much lower risk than speculation on the stock market. In fact, government backed bonds are considered to carry no risk at all as any purchaser of government bonds is absolutely guaranteed to receive their initial investment back plus the interest earned on that capital amount. Whereas the low risk factor is extremely attractive to cautious investors, low risk bonds do not return the potential amounts that can be earned on the stock market.
The rule of thumb to investment and speculation is more or less as follows: lower risk inevitably equates to lower but more reliable returns, and higher risk instruments lead to higher, but less reliable returns on initial investment amounts.
Simply put, bonds are one of the instruments used by the private and public/governmental sectors to generate income for either current expenditure or further investment. Government issued bonds are often used to fund infrastructure projects.
A bond is categorised as a debt security, which is essentially a relationship in which one party issues a promise to repay, with an agreed upon interest, a lending party the amount borrowed. The bond issuer therefore borrows capital from a lender (the bondholder), and guarantees that the funds borrowed will be returned, in full, on a specified date (usually). However, because of inflation and the current consumption foregone by the lender (see earlier on this website), the bond issuer has to pay interest on the amount borrowed: the interest charged is understood to be the price for borrowing money.
The interest payments are done via regular coupon payments which are a set and consistent amount of money. The relationship between the initial amount lent out and the bond’s assured coupon amount together act to establish the interest that the bondholder earns from the investment. For example, if a bond is bought for R1000-00 and the bond issuer pays the bondholder a coupon totalling R100-00 per year, the annual interest rate on the bond is 10%.
Coupon payments are made to the bondholder on either a monthly, bi/semi-annual or annual basis. After a predetermined period, the bond issuer ceases to pay the coupon (interest) instalments, and repays the bond’s principal/nominal amount. At this point the bond is said to have reached maturity, and the bond issuer has no further obligations to the bondholder.
With regards to inflation, the total interest earned on the principal amount (the accumulated value of the bond’s set coupon payments) must at the very least equal the average inflation level for the period over which the bond was held in order for the bondholder not to lose money through inflation induced depreciation.
With regards to risk, this component within interest rate determination is centred on the creditworthiness of the individual bond issuer. The lower the creditworthiness of the bond issuer, the higher the amount of risk assumed by the bond purchaser, and in order to obtain investment, the issuer will therefore have to offer a higher bond yield (higher coupon values) to attract bond purchasers.
As stated, government bonds are generally considered as having no risk, and have lower (but guaranteed) yields than junk bonds (high risk bonds with potentially high yields).
Bonds are long term investments: all instruments, including certificates of deposits and commercial paper, which repay the lender within a year, are called money market instruments. Short term bonds (which are repaid anytime during the period of between one and five years) are often referred to as “bills”; medium term bonds (bonds that reach maturity during the period of six to twelve years) are “notes”; and long term bonds (bonds reaching maturity after twelve years are referred to as “bonds”.
Private companies and corporations may also raise investment funds by the issuing of stocks to current and new stockholders. The primary difference between stocks and bonds resides in the method through which investors earn returns on their investments. Whereas bondholders earn interest on their nominal investment, which is repaid when the bond comes to maturity, stockholders are given an equity share in the company. Stockholders therefore own part of the company in which they have invested, and do not receive a repayment of their principal investment: instead, stockholders earn dividends of the company’s profits based on the portion of the company that they own. Stocks can therefore, at least theoretically, be held indefinitely; the only bond without a maturity date is a perpetuity. Over a long enough period of time, however, and due to inflation induced depreciation, the interest payments on a perpetual bond become close to being worthless.