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.