Fundamentals 101 – Bonds

Unlike a stock, bonds are typically not in the news (and if they are, they tend to be very bad news). However, bonds are an important piece to building a strong investment portfolio, and are particularly important if you're reaching retirement, or are not a fan of potentially losing money.

What is a bond

The easiest way to think of a bond is to lend some entity money in return for interest and to get the money back in the future.

How does a bond work

Before we go into talking about bonds, let's use an example.

You could lend RM1000 to a friend for 1 month, and the friend might buy you a nasi ayam from Village Park (say it costs RM10) one month from now (on top of returning your money). In this case, you got RM10 (in food) for the RM1000 you lent, which is a 1% return in 1 month (or 12% in one year, if you can constantly find friends who are willing to give you that offer).

Now let's replace the friend with a company. Let's replace the Nasi ayam in 1 month (1% in 1 month) with 1% every 3 months, and let's change the payback period to be 1 year.

Now you could lend RM1000 to a company for 1 year, and the company will pay you 1% (RM10) every 3 months. And at the end of the year, pay you back the money.

That means you would get paid RM10 on months 3, 6, 9 and 12. This is known as interest.

In total, you would get RM40 in interest and your RM1000 back.

In other words, you would get 4% in interest on this company bond.

But let's say before the year is over, the company that you lent your money to, runs out of money and goes bankrupt. At that point of time, you may lose part of the money you lent.

The reason it's "may lose" as opposed to "will lose" is because everything the company owns (property, equipment, office chairs etc) will then be sold off to pay as many of their bondholders as possible.

Different types of bonds

At the most basic level, there are 2 types of bonds. You have bonds from the government, and bonds from companies.

Government bonds tend to be safer than corporate bonds because the chances that a government (country, state, city etc) goes bankrupt is much lower than the chances of a company going bankrupt.

That is why government bonds tend to give you a much lower interest rate than a company bond.

What should you do with this information

This is just a basic understanding of how bonds work. There are many other parts that play a role in the price of a bond, and some of those parts can be very important (but out of the scope of this article).

That said, bonds tend to be a great investment as you get closer to retirement because bonds are structured in a way that gives you a lot more certainty (in terms of how much it will pay, and when you will get all your money back) compared to a stock.

The easiest ways to get access to bonds is to either talk to your bank directly, or to buy a unit trust that focuses on buying bonds.