Advantages and Disadvantages of Bonds
Advantages of Bonds
Definition and Purpose of a Bond
In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security under which the issuer owes the holders a debt and, depending on the bond terms, is obliged to pay them interest (the coupon). In addition, the issuer might have to repay the principal later, which is termed the maturity.
Interest is
usually payable at fixed intervals (semiannual, annual, and sometimes
monthly). Very often, the bond is negotiable; in other words, the
ownership of the instrument can be transferred in the secondary market.
San Francisco Pacific Railroad Bond A bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security under which the issuer owes the holders a debt and, depending on the bond terms, is obliged to pay them interest (the coupon). In addition, the issuer might have to repay the principal later, which is termed the maturity.
Bonds are bought and traded mostly by institutions like central banks, sovereign wealth funds, pension funds, insurance companies, hedge funds, and banks. Insurance companies and pension funds have liabilities,
including fixed amounts payable on predetermined dates.
They buy the bonds to match their liabilities and may be legally compelled. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly 10% of all outstanding bonds are held directly by households.
Advantages of Bonds
Bonds have a clear advantage over other securities. Their volatility (especially short – and medium-dated bonds) is lower than that of equities (stocks), so bonds are generally viewed as safer investments than stocks. In addition, bonds suffer from less day-to-day volatility than stocks, and their interest payments are sometimes higher than the general level of dividend payments.
Bonds are often liquid. It is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much, which may be more difficult for equities. In effect, bonds are attractive because of the comparative certainty of a fixed interest payment twice a year and a fixed lump sum at maturity.
Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's equity stock often ends up valueless. Furthermore, bonds come with indentures (an indenture is a formal debt agreement that establishes the terms of a bond issue) and covenants (the clauses of such an agreement). Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing.
There are also a variety of bonds to fit different needs of investors, including fixed rated bonds, floating rate bonds, zero coupon bonds, convertible bonds, and inflation linked bonds.
Key Points
- Bonds are a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and or repay the principal at a later date, which is termed the maturity.
- The volatility of bonds (especially short and medium dated bonds) is lower than that of equities (stocks). Thus bonds are generally viewed as safer investments than stocks.
- Bonds are often liquid – it is often fairly easy for an
institution to sell a large quantity of bonds without affecting the
price much.
- Bondholders also enjoy a measure of legal protection: under the
law of most countries, if a company goes bankrupt, its bondholders will
often receive some money back (the recovery amount).
- There are also a variety of bonds to fit different needs of investors.
Terms
- Inflation-Linked Bonds (also known as inflation-linked bonds or colloquially as linkers) – bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment.
- Zero Coupon Bond (also called a discount bond or deep discount bond) – a bond bought at a price lower than its face value, with the face value repaid at the time of maturity.
- Convertible Bond – a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price.
Source: Boundless Finance, https://ftp.worldpossible.org/endless/eos-rachel/RACHEL/RACHEL/modules/en-boundless-static/www.boundless.com/finance/textbooks/boundless-finance-textbook/bond-valuation-6/advantages-and-disadvantages-of-bonds-65/index.html
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