Bonds are financial instruments issued by companies, municipalities, or the Ghanaian government to raise capital for their financing needs. Bonds can be seen as a loan owed by the issuing entity (bond issuer) to the lenders (bondholders) with a set payment schedule. Bonds are classified as fixed income investments in the investing community, meaning they usually pay an interest payment (coupon) that is the same, or fixed, throughout the life of the bond.
As a result, the bondholders receive periodic interest payments at predetermined intervals over the life of the bond, usually once or twice per year. The interest payments are determined by the coupon rate at issue and are paid if a bond is held to the end of its issued life. Upon maturity of the bond, the principal value is repaid along with the final interest or coupon payment. For example, a semiannual 10-year bond of GHS 1,000 par value issued with a 3 percent coupon rate has interest payments of GHS 15 (3% × 1000 × 1/2) paid twice per year over a period of 10 years. At maturity, that is, at the end of 10 years, the principal of GHS 1,000 is repaid along with the final GHS 15 coupon payment.
Bonds are secured by the assets of the bond issuer and are said to be in default if the issuer misses a payment. In case the bond issuer files for bankruptcy, bondholders as creditors have a right of lien on the bond issuer’s assets.
Risk
Bond investors can suffer losses if the issuer defaults on its debt obligations, leading to a decrease in the bond’s value. The risk of default varies based on the creditworthiness of the issuer and the terms of the bond. Investing in bonds carries its own set of risks, and investors may experience losses in several situations:
- Default Risk: Bondholders face the risk of default, which occurs when the issuer fails to make timely payments of interest or principal. If the issuer is unable to fulfill its debt obligations, bondholders may suffer losses. The level of default risk varies depending on the creditworthiness of the issuer. Higher-risk bonds, such as those issued by financially unstable companies or countries with weak credit ratings, generally carry a higher probability of default and, therefore, greater potential for losses.
- Credit Risk: Even if a bond issuer does not default, changes in the issuer’s creditworthiness can affect the bond’s value. If the issuer’s credit rating is downgraded by credit rating agencies, the bond’s market value may decline. Factors that can impact credit risk include changes in the issuer’s financial health, industry conditions, or market perception of the issuer’s ability to meet its debt obligations.
- Interest Rate Risk: Bonds are sensitive to changes in interest rates. When interest rates rise, existing bonds with lower coupon rates become less attractive to investors. This can result in a decrease in the market value of the bonds. Conversely, when interest rates decline, bond prices may rise. Therefore, if an investor needs to sell a bond before its maturity, they may incur a loss if interest rates have increased since the bond was purchased.
- Inflation Risk: Inflation erodes the purchasing power of future interest and principal payments. If the interest rate earned on a bond does not keep pace with inflation, the bond’s real return may be negative. Inflation can decrease the bond’s purchasing power and impact its value in the secondary market.
- Call Risk: Some bonds have call provisions that allow the issuer to redeem the bonds before their maturity date. If the issuer exercises this right, bondholders may receive the principal amount earlier than expected, potentially reinvesting at a lower interest rate. This can result in a loss of future interest income and potential capital appreciation.
It’s crucial for bond investors to carefully assess the creditworthiness of the issuer, understand the terms and conditions of the bond, and diversify their bond holdings to mitigate risk. Additionally, staying informed about economic conditions, interest rate movements, and market trends can help investors make informed decisions and manage their bond investments effectively.
