Question

Explanation of the importance of Bonds and one way it can be applied in the real world

Answer 1

A BOND is a debt instrument created for the purpose of raising capital. They are essentially loan agreements between the bond issuer and an investor, in which the bond issuer is obligated to pay a specified amount of money at specified future dates. A bond is also known as a fixed-income security

Different types of bonds offer investors different options. When an investor purchases a bond, they are "loaning" that money (called the principal) to the bond issuer, which is usually raising money for some project. When the bond matures, the issuer repays the principal to the investor. In most cases, the investor will receive regular interest payments from the issuer until the bond matures.

For example :- There are bonds that can be redeemed prior to their specified maturity date, and bonds that can be exchanged for shares of a company. Other bonds have different levels of risk, which can be determined by its credit rating.

Bonds and other fixed-income securities play a critical role in an investor's portfolio. Owning bonds helps to diversify a portfolio, as the bond market doesn't rise or fall alongside the stock market. More important, bonds are generally less volatile then stocks, and are usually viewed as a "safer" investment.

There are 6 ways that investors use bonds

1. Preserving Principal
2. Saving
3. Managing Interest Rate Risk
4. Diversification
5. Expense Matching
6. Long Term Planning

One of the most common uses of bonds is to preserve principal. Since bonds are essentially loans with scheduled repayments and maturities, lenders (bondholders) can expect their bonds to retain value and terminate at par upon maturity. This is a simplified version of the life of a bond: there can actually be significant volatility as prevailing interest rates change and affect the value of the bond. A risk-free bond purchased at par and held to maturity should preserve principal, mature at par and provide a dependable cash flow.

None of these strategies will work if the bond's coupon payments or the return of its principal become uncertain. Bonds of all qualities carry inherent risks, such as credit, default and interest-rate risk. The credit and default risk can be mitigated by purchasing only investment-grade or U.S. government securities. It's important to note that even bonds that are considered investment grade can quickly fall below this standard. Interest-rate risk can also be mitigated just by holding the bond to maturity, as the par value will be returned upon maturity.

Individuals and institutions can use bonds for long-term planning, preserving principal, saving, maximizing income, managing interest-rate risk and diversifying portfolios. Bonds provide a predictable stream of coupon income and their full par value if held to maturity.