Have you ever forgotten to bring enough money and had to borrow from someone? There are many reasons as to why we need to borrow money but all of us have had to borrow money sometime in our lives.

Similarly, companies, and even governments, might need to borrow large sums of money from time to time and they do this by issuing bonds.

What Are Bonds?

Alongside Stocks, Bonds fall under the other traditional investment class called “Fixed Income”. As the name of their investment class says it, Bonds are a good source of regular/periodic, fixed income. They are basically loans where you are the lender and the companies or governments which issue the bonds (bond issuers) are the borrowers. Aside from promising to return you the borrowed amount (principal) at a certain date (maturity date), they will need to pay you interest (the interest payments are officially called 'coupons'), usually at regular intervals, until the maturity date. Aside from stocks, bonds are also a form of financing for bond issuers.

The main difference between stocks and bonds is that the company guarantees to pay you back your principal, plus interest. You know exactly how much you are going to get back, and when you are going to get it.

Many bonds are long-term loans/fixed income investments, with a maturities extending even to 30 years! Bonds with shorter maturities of around 3-5 years are often termed ‘short duration bonds’. Meanwhile, fixed income investments with less than 1 year to maturity are known as money market instruments.

How Risky Are Bonds?

Although the company whom you lent your money to guarantees to pay you back, it does not mean that Bonds are risk-free.

Companies, and even governments can, and do go bankrupt. However, when that happens, you (the bondholder) will be at the front of the creditors' line, while stockholders would be at the rear of it.

But perhaps the most risky thing to bondholders is rising inflation rate. When the economy is booming and unemployment rates are falling, that is when bonds and bondholders suffer the most (the reverse applies. Recessions are great for bonds!). Inflation causes prices of things in general to rise. This means that $10 in the future would be able to buy less goods and services than $10 now. So your fixed fee from bonds would buy you less if there was inflation.

Put into context, this also means that the money which you get back when your bond matures would be worth a lot less than what it is worth today when you loan it out. So the faster inflation rises, the faster your bond loses value.

Interest Rates

Interest rate is another thing bond investors watch out for. Rising interest rates cause bond prices to fall, and vice versa. This is because bonds pay a fixed coupon. As interest rates fall, people are willing to pay more money for the bond because its fixed coupon may represent a higher return than interest income. Conversely when interest rates rise, people are less willing to hold on to bonds because interest income would be higher than the fixed coupon, hence leading to a fall in bond prices (or what's called capital depreciation).

Bond Unit Trusts

If you see bonds as an essential part of your investment portfolio, but yet lack the time or investment capital to buy into local bonds (which can be very high in value), then you may opt to invest in a Bond Unit Trust instead. Bond unit trusts are basically a collection of different types of bonds. Instead of an individual bond, you are buying into a ready portfolio of bonds.

A lot of people opt for bond unit trusts when they seek to diversify their investments with some fixed-income exposure. Even 'growth' investors invest in bonds as it helps to stabilise their portfolio returns.