With what has been happening in the recent financial market over the past few months, investors now need to be cautious as to what to invest in and their choices from the various securities that are available for investment. Today we will discuss one such investment, namely bonds and how they really work.

Alison Lue-Taim

Let us first start out by defining what a bond is. A bond is the most common type of debt instrument and is similar to an "I Owe You" (IOU). When you purchase a bond, you are lending the money to a government, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it "matures" or becomes due. Bonds are also referred to as "fixed income securities".

Now that you have a fair idea as to what a bond is you are probably asking yourself why own bonds? Well here is the answer to that. Bonds are a good choice of investment if you are looking to earn a steady income with the potential to beat inflation. They pay you interest based on a fixed rate for a specified period of time. Thus before you can even consider purchasing a bond, here are some questions you need to ask yourself:

1. How much will I earn? The amount you earn will be based on the bond's face value, the coupon rate and the yield. I will define each for you in detail starting with the face value. Now this is otherwise called the par value of a bond which is the value of the bond at maturity that is the date at which the loan is paid off.

The bond's coupon rate refers to the interest rate that will be paid based on the face value of the bond. For example: if the bond has a face value of $1,000 with a coupon rate of seven per cent per annum, then your interest that will be paid to you will be $70 each year.

2. When will I be paid interest? Interest may be paid out quarterly, semi-annually or annually depending on the terms of the bonds, and the dates on which interest will be paid are also specified when the bond is first issued.

3. How safe is your bond? And how reliable is the borrower? When you buy bonds, you as an investor need to be aware of the various credit ratings that are assigned to the various bonds you are intending to purchase. Right now there are two major rating companies, known as Moody's and Standard and Poor's, which rate the credit worthiness of bonds. These ratings are based primarily on the history of the issuer of the bond and their current financial status. The ratings use a letter system and will allow you to determine the best bond for investment. It is however suggested that the safest US dollar bonds are those bonds issued by the US federal government agencies or the federal government itself. Below I will discuss the various letters used to rate these bonds and what they mean so that you will have an idea:

AAA is the highest rating assigned by Stand and Poor's. This means that the bond issuer will be able to meet its financial commitment, is extremely strong and it has the smallest degree of credit risk.

AA this rating differs from AAA only by a small degree. Here the bonds have high quality by all standards and the bond issuer's capacity to meet its financial commitment on the bond is very strong.

A this rating is affected negatively by changes in the world's economic conditions.

BBB this rating shows signs of adequate financial protection. That is, unfavourable economic conditions or changing circumstances are more likely to weaken the bond issuer's ability to meet its financial commitment.

BB, B, CCC, CC, C these ratings will have significant amount of risk, even though they may have some positive qualities. BB indicates the least amount of risk while C will have the highest amount of risk.

D a bond rated D will default on payment.

4. Do interest rates affect prices? Yes indeed interest rates and bonds work like a see-saw, that is when rates rise, bond prices tend to fall and when rates fall bond prices tend to rise. However if you hold a bond to maturity, you will not face any of these price changes, but if you decide to sell it before maturity you may end up losing a portion of that which was invested.

Interest rates can also influence an issuer's decision to pay off the bonds early. Just as you can pay off your mortgage at any time without a penalty, many bond issuers have the ability to 'call' in the bonds early. Thus if the bond is called or redeemed by the issuer before maturity you will be entitled to your principal plus any interest.

5. How long are you willing to tie up your money? Time plays a big role in how much risk you are willing to take and how much interest you will be paid. There are three main time-based categories of bonds: Short-term bonds (generally under two years); Intermediate-term bonds (generally 2-10 years) and Long-term bonds (generally more than 10 years).

6. How can you manage risk? To help manage these risks, it is best to hold a wide variety of bonds with different maturity dates from various institutions, so in other words, diversify your portfolio.

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