Before you invest in a specific bond, there are many factors that should be analyzed and considered. Bonds, although considered comparatively safer than stocks, also carry some inherent risks. To know those risks and to see whether the bond performance fit your goals and risk tolerance, here are some of the most important factors you should take into account.
The very first thing you should consider is the price of the bond. The yield you will receive on the bond affects the pricing.
Bonds either trade at a premium, a discount, or at par. Trading at a premium to its face value means that the yield the bond is paying is higher than the prevailing interest rates. Thus, the bond trades at a higher price than its face value because you are entitled to higher interest rates.
Meanwhile, it is trading at a discount if its price is lower than the face value, meaning the bond is paying a lower rate than the prevailing interest rate. And because you can attain higher interest rates easily in other fixed income assets, there is less demand for a lower interest rate in bonds.
Lastly, when the bond is trading at par, it is trading at face value. The par value is the value at which the issuer will take back the bond at maturity.
Interest Rate and Yield
The bond’s interest rate is the rate that the bond will pay until its maturity. Such bond rate can be fixed, floating, or only payable at maturity. The most common bond rate in the market is a fixed rate until maturity that is a portion of the bond’s face value.
There are issuers that sell bonds with floating rates that reset the interest rate depending on a benchmark like Treasury bills or LIBOR.
The bonds that pay interest only upon maturity are called zero-coupon bonds and they can be sold at discounts to their face value.
The maturity of the bond refers to the future date at which the principal will be repaid. In general, bonds have maturities of anywhere from one to 30 years. Short-term bonds have maturities of one to five years. For medium term bonds, maturities last from five to 12 years. And long-term bonds, lastly, have maturities that exceed 12 years.
When considering the interest rate risk, the maturity of the bond is an important factor. The interest rate risk is the amount that a bond’s price will rise or fall depending on the increase or decrease in interest rates. In simple terms, longer maturity means greater interest rate risk.
There are bonds that allow issuers to redeem the bond ahead of the maturity date. This lets the user to refinance its debt if ever the interest rate falls. A call option or provision will allow the user to ‘call back’ the bond at a specific price and date prior to the maturity. A put provision, on the other hand, lets you as the investor to sell it back to the issuer at a specific price head of the maturity.
A call provision usually pays a higher interest rate. If you hold such a bond, you are taking on more risk that the bond will be redeemed and you will be forced to reinvest at a lower interest rate.