Wednesday, March 28, 2012

Essay on Investing

Essay on Investing in Stocks and Bonds

Capital markets, debt instruments, derivative securities, promissory notes, common stock … we hear such terms from day to day and many people consider these to be extremely complicated and beyond their comprehension. However, behind these horrible words there are hidden quite simple and straight-forward things. In this paper I would like to reveal the nature of bond as a basic financial instrument. Besides defining the term bond, I will review the types and issuers of bonds and try to make bonds easier for understanding.

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As many people know the primary elements of capital markets are shares and bonds. Bonds represent debt capital, which is a kind of a loan. The interest (coupon rate) is fixed as a percentage of the principal and is paid annually or semiannually; therefore bonds are considered to be fixed interest instruments in contrast to shares. Although bonds yield lower return than shares, they expose investor to less risk and can be traded in the market as shares and other financial instruments.

As we already stated, bond is repayable over a specified period of time, which is referred to as maturity period. When this period is over the issuer will pay last interest payment to the bondholder and redeem the bond (repay the principal).

The issuer of a bond is the primary distinguishing feature of this financial instrument. Government bonds (both sovereign and local) are believed to be the most secure ones. They are traded in domestic and foreign capital markets to raise finance for some government capital projects. Corporate bonds are more risky and offer higher yield to investor as a premium for accepting such risk. Corporations use bonds as a source of debt capital.

There are many types of bonds that can be issued. The most common types are listed and reviewed below:

- conventional bond (the basic bond type, which has fixed maturity date and fixed coupon rate; other bond types are derivatives from conventional);

- government bond (issued by the government or its agency; e.g. US Treasury bond);

- floating-rate note (the coupon rate of such bond is linked to bank lending rates and therefore varies during the lifecycle of the bond);

- index-linked bond (coupon rate is linked to some finance index like index of commodity prices or inflation);

- zero-coupon bond (it is issued at discount and implies no periodic coupon payments; the interest is realized in the discount (e.g. 10% of the bond price) and is paid on the redemption – bondholder receives 100% of the bond price instead of 90% that were paid for it);

- Eurobond (issued by governments and corporations and traded as international securities);

and many others.

So far we have defined the term bond, discussed it in details and covered issuers and common types of bonds. Apparently, this topic is rather easy and the devil is not so black as he is painted.
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