What are Bonds?
Bonds are the lesser known cousins of stocks. We all get to know stocks since an early age. They are a part of dinner table conversations. However, bonds are less familiar, especially amongst retail investors. Bonds can outperform stocks and even have lower volatility compared to stocks.
Investors downside is typically capped when investing in bonds. In the event of a liquidation of a company, bond holders must get paid first, before stock holders. Bonds also pay regular coupons and hence there is greater certainty of recurring income to the investor. This feature is especially important for pension and retired investors who would be dependent on a regular stream of income to fund their expenses.
Lets test your knowledge of some basics facts about fixed income securities – also called bonds!
Results
Good job! You know your basics well !
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#1. True or false: The bond market is larger than the stock market.
According to some estimates, the bond market tripled between 2000 and 2016, and now exceeds $100 trillion. In the same period, the value of the global stock market was only around $64 trillion.
#2. True or false: Bonds are safer than stocks.
The answer to this question can really vary. In theory, bonds are supposed to be safer than stocks. However, this is a generalized statement. And on many occasions, bonds can be a much more risky investment than stocks. For instance, buying bonds of a very poor credit quality vs buying stocks of large, blue chip companies like Apple or Microsoft.
Bond prices can also vary dramatically when interest rates change. This happens because investors prefer getting rid of low-yielding bonds in order to buy newly-issued, higher yielding bonds.
#3. Each of the following terms are connected to the price / value of a bond, except...
The issue price is the amount it costs to buy the bond from the issuer on the first day it was offered for sale. The par value is the face value of the bond, and the trading price is the bond’s value when bought and sold.
#4. What is a convertible bond? A bond which …
Companies often offer convertible bonds when they want to lower the payment rate on their debt. These are great for investors if there is a sharp increase in the company’s stock value. If that doesn’t happen, they still get the principal amount when the bond matures. It’s a win-win!
#5. What does it mean when a corporate bond is “callable”? The issuer can …
Callable bonds typically have a higher interest rate, as there is the risk that the bondholders will lose on their interest yield if the bond is retired early.
#6. Who are the largest players in the bond market?
Governments are typically the largest issuers of Bonds. The US government is the largest issuer of debt / bonds in this world. A whopping US$26 trillion ! China comes second and Japan ranks third.
#7. Why do governments of countries purchase debt from other countries?
Governments play one of the largest roles in the bond market because they borrow and lend money to other governments and banks. Furthermore, governments often purchase debt from other countries if they have excess reserves of that country’s money as a result of trade between countries. For example, China and Japan are major holders of U.S. government debt.
#8. What term is commonly used for bonds that used to be investment grade, but are now classified as junk?
Junk bonds are divided into two classifications, namely fallen angels and rising stars. Rising stars, being the opposite of fallen angels, are bonds that were classified as speculation grade when issued, but whose financial stability has improved.
#9. If a company's bond rating gets downgraded to junk status from investment, what would be the most likely immediate outcome?
Pension funds and investment products designed for retirement savings can only invest in investment-grade instruments. Therefore, they are obligated to immediately sell bonds if downgraded to junk status, which causes bond prices to tumble.
#10. Why would an investor typically buy junk bonds?
Junk bonds’ higher interest rates mean that investors can earn more than with less risky bonds.
