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What are bonds?

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A bond is a financial liability issued by a company or the government and placed among investors as an investment instrument. By purchasing a bond, an investor provides borrowed funds to the issuer for a certain period of time, with the obligation to pay interest and repay the loan (par value) at the end of the term.

Thus, bonds provide companies and states with an opportunity to attract additional financial resources, and investors – to receive a stable income from their investments in the form of interest payments. The frequency of interest payments is usually once or twice a year, and the terms vary depending on the terms of a particular bond.

Here is an example: purchasing a $100 bond with an annualized yield of 10%. This implies that after one year, the investor will get back $100 and an additional $10 in interest.

There are a variety of bond types including corporate, municipal, government, and collateralized and non-collateralized. Bonds can be sold in the primary market at the time of initial issuance or in the secondary market where they are traded after issuance through an exchange or broker.

Varieties of bonds

  • Fixed coupon – interest payments will remain constant throughout the term of the bond.
  • Floating coupon – interest payments will change according to the market rate.
  • Zero-coupon – pays no interest over the term, but is sold at a discount (reduced price) to face value.
  • Convertible bonds – have an option to convert into shares of the issuer at a predetermined rate.
  • Non-redeemable (perpetual) bonds – have no definite maturity date and pay interest forever.

Risks of investing in bonds

  • Market risk is the possibility that the value of the bond may decrease as a result of changes in market conditions (for example, an increase in interest rates or deterioration of the issuer’s financial position).
  • Credit risk – the possibility that the issuer will not be able to pay interest or redeem the bond at maturity.
  • Inflation risk – the possibility that inflation will reduce the real value of bond payments in the future.
  • Liquidity – the possibility that the bond will be difficult to sell in the secondary market.

How to invest in bonds

  • Buying bonds on the primary market from banks or investment companies that sell bonds.
  • Buying bonds on the secondary market through a broker or online trading platform.
  • Investing in investment funds or ETFs that invest in a portfolio of bonds.

Why have bond prices fallen?

Banks in the US faced a crisis due to a sharp rise in bond yields, which led to a decline in their market value. The situation was exacerbated as banks used funds raised from customers on deposits to purchase bonds. In doing so, bond yields were higher than the interest on deposits, giving the appearance of a solid plan like a Swiss watch.

However, after the Federal Reserve System (FRS) began raising interest rates, bond yields rose. It is worth noting that the terms for already issued bonds could not be changed and banks purchased them at a predetermined yield, such as 1%. While new bond issues offered higher yields, reaching, for example, 4%.

Bonds, as an investment instrument, can be bought and sold in primary and secondary markets. An increase in interest rates by the Federal Reserve increases the yields on new bond issues, causing the prices of previously issued bonds to fall. This is because investors are not interested in buying bonds with low yields if bonds with higher yields are available. Consequently, bonds with low yields are sold in the secondary market at a price below their face value.

In case of mass withdrawal of customers from banks, the latter are forced to sell bonds in the secondary market even at a lower price than the par value. This exposes banks to real losses, not just paper losses, especially if bond prices fall below par.

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