There is risk involved with every kind of investment. The greater the risk, the greater the potential reward. Investors who have a low tolerance for risk are willing to forgo higher rates of return in exchange for confidence that their chances of experiencing significant losses are lower. And in the arena of low-risk investments, nothing is more attractive than bonds.
A bond is a type of investment in which the purchaser is essentially loaning money to the seller. Bonds are sold by corporations and government entities in need of cash to finance capital improvements, new projects, or even debt consolidation. Bond purchasers are, in a legal sense, creditors of the entities that issue them.
Bonds can be sold with variable or fixed interest rates. Because fixed rate bonds make up the lion's share of those available to the general public, we will focus only on these in this article. Suffice to say that a fixed rate bond could be the right investment if you are looking to invest a lump sum in something that is relatively stable and risk-free.
How Fixed Rate Bonds Work
Let's say the Acme Widget Company wants to build a brand-new plant to support future growth in Europe. The company is profitable, but they do not have the millions of pounds necessary to cover construction costs. They could go to a traditional commercial bank to try to raise the money, or they could issue bonds instead.
Issuing bonds is one way for Acme to raise the cash needed at a lower cost than borrowing from the bank. If they do well on their bond offering, it may encourage purchasers to reinvest in the company in the future, providing necessary capital that could fund long-term growth. In this sense, issuing bonds offers several incentives that borrowing from a bank cannot.
Once the decision has been made to issue bonds, Acme will determine face value (also known as 'par') and the fixed interest rate. This fixed interest rate is known as the 'coupon'. Acme must also determine a maturity date that will become a contractual obligation once selling begins.
Coupon rates are typically linked to the prevailing interest rate at the time bonds are issued. That means if the current interest rate is 5% when Acme begins to issue their bonds, they are likely to set a coupon rate of 5% with a standard par value of £100 or £1000. A bond with a £100 face value and 5% coupon would earn £5 per year for each year it is held.
How Interest Rates Affect Bonds
We opened this article by reminding readers that every investment comes with risk. So what is the risk with fixed-rate bonds? After all, a bond offering a 5% coupon will accumulate interest every year through maturity – regardless of how the overall market does. In that sense, there is no risk unless the issuer completely fails. But there is some indirect risk to consider.
The value of fixed rate bonds is inversely proportional to prevailing interest rates. At the first issuance of a bond, both the issuer and the investor break even because the coupon rate is identical to prevailing interest rates. Again, we will use the example of a bond with a 5% coupon.
If the prevailing interest rate drops to 4%, the value of that bond with a 5% coupon is obviously higher. More people will be motivated to buy any outstanding bonds until the amount of cash raised reduces the effective value of the bonds to 4%. On the other hand, any increase in the prevailing interest rate to 6% makes the bond less attractive because its coupon is 5%. Fewer people will purchase, driving the price of those bonds down until the effective rate is once again 5%.
The risk you run with investing in fixed-rate bonds is one of interest rates rising. Instead of having the capital to invest elsewhere to take advantage of those higher rates, your money is locked in until bond maturity. You have not lost anything directly, but you may have lost indirectly by missing out on the opportunity to invest elsewhere.
Safe and Stable Investments
In summary, fixed rate bonds are a safe and stable investment that guarantee a certain level of return over a fixed period of time. They are good investments for the purposes of adding stability to a portfolio with a higher level of risk. They are also good for first-time investors just getting their