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what are bonds ?
bonds are instruments to borrow money . if a government or a state or a company wants to borrow money , it floats bonds in the market .
Each bond has three components
- a value – the principal
- an interest rate , also called the coupon rate – this is the interest rate paid per year
- duration – how long will the bond be for?
eg if a bond is issued for 10,000 at an interest rate of 5 % per year for a duration of 5 years , each year , the lender ( you, who is purchasing the bonds ) will be given an 500 for each year and at the end of 5 years , you will get back your original amount ( 10,000 )
there are risks to bonds
default risk – the company or state or government that you are buying the bond from might go bankrupt – in this case , you are likely to lose your money
liquidity risk – the company loses it’s popularity among the investors and it’s credit rating goes down .. which means lesser investors and lower prices
the bonds are rated by rating agencies – from AAA to D – AAA being the highest rating bonds , D being the worst.
The bonds which don’t gather much interest from the investors have to increase the interest rate.
generally the bonds for a shorter period pay a lesser interest than the longer duration.
if , for some reason , the lower duration bonds pay a higher rate than the longer duration bonds , this is called the inverted yield curve – it happened in september 2019 in the usa . it is an indicator of low inflation in the coming years. also is a leading indicator of a recession.
bonds are kept in the portfolio along with stocks so as to smoothen out the volatility of stocks and provide a steady stream of income in the form of cash returns .
bonds can be bought or sold after the initial purchase in a market called the secondary market.
bonds rates move in the opposite direction to the central bank interest rates . when central bank interest rates fall, more people move to the bonds , driving up their value .
When central bank interest rates rise , more people jump towards these rates and the interest in bonds falls , reducing the bond rates.