Bonds And Investing In Them

Making an investment is more than just putting money in a savings ac­count or purchasing property. Today, investors have a range of products to choose from. These include term deposits,
16 Jun 2018 10:00
Bonds And Investing In Them

Making an investment is more than just putting money in a savings ac­count or purchasing property.

Today, investors have a range of products to choose from.

These include term deposits, shares or units, fixed income securities such as bonds, and other products.

This article will focus on investing in bonds.

What are bonds?

A bond is a type of investment where the investor (the bondholder) lends money to a borrower (the issuer) e.g. government, statu­tory authorities or a company. In exchange, the issuer gives the investor a bond certifi­cate, which acts as proof that the issuer owes money to the bondholder. Bonds can be sold to other investors.

In some ways, a bond is similar to a bank loan.

The issuer pays the bondholder interest in equal amounts (called coupons) throughout the life of the bond.

Bond investment terms (time periods) vary but are always far greater than one year.

At the end of the bond term, the issuer pays the amount borrowed back to the bondhold­er along with the final interest payment.

In Fiji, bonds are mainly issued by the Fi­jian Government and a number of statutory bodies such as the Fiji Development Bank and the Housing Authority of Fiji.

Bonds may also be issued by private sector organisations and these are called corporate bonds.

General Bond Example

We will use an example to help illustrate the flows of money when investing in a bond and to familiarise the reader with bond terminology.

In this example, the price of a five year bond that pays an interest rate of 6 per cent per annum is $100.

By investing in the bond, the bondholder is lending $100 to the issuer for a period of five years (also known as the life of the bond). The face value is $100 and is the same amount the investor receives at the end of the bond life.

The interest rate or coupon rate is 6 per­cent and is paid out to the bondholder each year.

This means that for every year through­out the life of the bond, the bondholder receives coupon payments totalling $6 by year end.

Bond interest payouts may be made monthly, every three months, six months or yearly depending on the frequency of coupon payments. The Fijian Govern­ment “Viti Bond” is one example of a bond that pays out interest every three months. However, coupons on all other bonds is­sued in Fiji are paid semi-annually.

Why invest in bonds?

Bonds can be a good investment for sev­eral reasons. Let’s take a look at some of the benefits:

  • Regular income – the coupons provide a steady and regular income stream. This could be a means for receiving a consistent cash inflow with minimal risk to your invested capital.
  • Relatively low risk – bonds are basical­ly a debt which the issuer has a legal obligation to repay. This means that bondholders generally rank ahead of shareholders in priority. For example, if the issuer becomes insolvent and goes into receivership, bondholders and other people owed debts would be repaid first before ordinary sharehold­ers. Fiji’s bond market is concentrated with Government bonds which are generally considered low risk because the borrower is the national govern­ment.
  • Diversify your investment – adding bonds to your other investments can reduce your total investment risk. This is called diversification and can be de­scribed as “not putting all your eggs in one basket”. By spreading your money over several investments, you reduce the impact if one of your investments begins to lose money.


What are the risks of investing in bonds?

Like any other investments, bonds are not free of risk. Good investors consider and understand the risks of prospective invest­ments before they make investment deci­sions. Let’s take a look at some of the risks that apply to bonds.

  • Interest rate risk – interest rate and bond prices are inversely related. If interest rates in Fiji rise, the value of bonds held as investment will fall. This is driven by the lower demand for that particular bond coupled with competing alternatives of other invest­ment instruments.
  • Credit risk – this is the risk that the issuer may be unable to pay bondhold­ers. It depends on the quality of the issuer. For corporate bonds, a large, profitable and well-managed company is less likely to run into financial prob­lems and default on its payments than a company with a history of losses or poor management.
  • Liquidity risk – this is the risk that a bond cannot be easily sold at, or close to, its market value. The risk is higher where there is no market for bonds and investors may not be able to sell their bonds quickly or at the price they ex­pected.
  • Inflation risk – also known as Purchas­ing Power Risk, this risk arises from the decline in value of securities cash flow due to inflation, which is meas­ured in terms of purchasing power. For example, a bond is purchased with a coupon rate of 4 percent. The infla­tion rate is at 2 percent. Even though you are earning 4 percent on your money, inflation is chipping 2 percent of it away only leaving you with 2 per­cent of your money or purchase power, which you can use when you receive your payments.


Are bonds suitable for you?

Bonds can be a good investment but they won’t suit everyone. As bonds pay regular coupons, they can be a good option for inves­tors who want to receive regular income.

Since market interest rate changes in the short term can cause bond prices to fluctu­ate, bonds are generally more suited to long­er-term investors.

By holding bonds until they mature, the re­turns are more certain because the coupons and face value are known.

Ultimately, any investment must match your risk-return preference and particular circumstances.

Source: Reserve Bank of Fiji




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