InvestorQ : What are bonds and its a safe investment option available?
Manish Mehta made post

What are bonds and its a safe investment option available?

Rohan Bhadani answered.
2 years ago
Bonds are issued by governments and corporations when they want to raise money. By buying a bond, you're giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year. Once the bond reaches maturity, the bond issuer returns the investor’s money. Fixed income is a term often used to describe bonds, since your investment earns fixed payments over the life of the bond.

Companies sell bonds to finance ongoing operations, new projects, or acquisitions. Governments sell bonds for funding purposes, and also to supplement revenue from taxes. When you invest in a bond, you are a debtholder for the entity that is issuing the bond. Individual investors acquiring bonds have legal and financial claims to an organization’s debt fund. Borrowers are therefore liable to pay the entire face value of bonds to these individuals after the term expires. As a result, bondholders receive debt recovery payments before stakeholders in case a company faces bankruptcy.

Interestingly enough, inflation and interest rates play a crucial role in regulating the prices of bonds. Interest rates, usually set by a country’s central bank, influence the cost of borrowing and the return on savings. Policymakers at central banks use interest rates to influence inflation and economic growth.

For eg- The US Federal Reserve Board takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. Why? To try to slow the economy by making it more expensive to borrow money. When the Fed raises its target interest rate, other interest rates, and bond yields typically rise as well. 

What one must understand here is that- prices of bonds and their yield( a bond’s overall percentage rate of return on your investment at any given period of time) are inversely proportional to each other. Thus, when the Fed signals a rate increase, bond yields rise while its prices fall. That’s because bond issuers must pay a competitive interest rate to get people to buy their bonds. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall. That’s why bond prices can drop even though the economy may be growing.

An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.