What are obligations and how do they work?

What are obligations and how do they work?

Bonds are a financial instrument through which a investor lends money to a particular entity🇧🇷 It is, therefore, about debt securities issued by an entity which, instead of turning to a bank for financing, borrows money from investors. The requested amount is paid at the end of the term of the obligations.

Next, we highlight some concepts you should know related to obligations.

maturity date

An important concept to bear in mind is that of maturity date🇧🇷 That is, it is the date on which the entity must pay the amount owed to investors. Unlike a bank loan, the outstanding amount is paid in full at the end of the term.

With regard to maturity, obligations are classified in three ways:

  • Short term: bonds whose maturity varies between 1 and 3 years;
  • Mid-term: bonds whose maturity varies between 3 years and 10 years;
  • Long term: Bonds whose maturity exceeds 10 years.

Also to be mentioned are the perpetual bonds that do not have a maturity date predetermined, and in which the capital owed may never even be paid. Only interest is paid on a regular basis. However, are not a very common form of financing🇧🇷 Only heavily indebted governments have used this form of finance in the past.

Valor nominal

The par value of a bond is the amount to be repaid at the end of its term.🇧🇷 That is, if a company issues 1,000,000 bonds representing a total debt of €1,000,000, the nominal value of each bond is €1.

Generally, Bonds are issued at par, ie the price at which they are sold coincides with their nominal value.

Interest rate

As mentioned above, Investors in bonds are entitled to receive an interest rate, which is called a coupon..

With regard to coupon rates, there are several types of bonds, namely:

  • Fixed Rate Bonds: are the most common type. In this case, the interest rate paid is predetermined and does not vary over time. That is, if you buy a bond with a nominal value of 100 euros and an annual coupon rate of 5%, you will receive a coupon of 5 euros per year, until the maturity date;
  • zero coupon bonds: in this type of bonds there is no periodic payment of interest. There is only one single payment equal to the nominal value of the security, which is paid on the maturity date;
  • Variable Rate Bonds: in this case, a coupon is paid regularly, but its value varies over time, depending on a defined index. For example, it may vary depending on the evolution of Euribor rates;
  • Obligations linked to inflation: in this type, the coupon rate varies according to the evolution of the inflation rate. In the current situation they can be an interesting type of investment.

issuing entities

Issuing entities are those that issue bonds in order to finance themselves. We can highlight the following:

  • States or other public entities: the bonds serve to finance the provision of public services to its citizens;
  • private entities: the bonds are intended to finance the activities of companies.

Other types of obligations

In addition to the types of obligations already mentioned above, there are a few more that should also be highlighted, with regard to the guarantees they offer:

  • Convertible bonds: are obligations that incorporate a call option on the company’s shares. That is, the bond investor can exchange them for shares in the company;
  • Subordinated obligations: in case of bankruptcy of the issuer, they are the last obligations to be repaid;
  • Senior obligations: in case of bankruptcy of the issuer they are the first bonds to be repaid.

How does the value of a bond change over time?

The value of a bond is affected by a number of factors. Here are some of the main ones:

  • Evolution of interest rates: bonds, as a rule, vary in the opposite way to the evolution of interest rates. That is, when interest rates rise, the value of bonds falls. On the contrary, when interest rates fall, the value of bonds rises. This inverse relationship has to do with the fact that, in case interest rates are rising, they make the coupon rate of an older bond less attractive, when compared to new bonds issued in a post-increase context. of interest. In other words, in this scenario, investors tend to sell their bonds and exchange them for recently issued bonds;
  • Increased risk of bankruptcy of an entity: when the risk of bankruptcy of an entity increases, the value of the bonds decreases, since the coupon rate required by investors to buy these bonds increases.

to notice that the bonds are quoted on the market, and as such their value varies depending on that negotiation🇧🇷 However, regardless of these market fluctuations, the nominal amount to be repaid at the end of the period always remains the same.

Also read: Investing in bonds: What you need to know before investing

The benefits of investing in bonds

Among the advantages of investing in bonds is the income predictabilityin the case of fixed-rate bonds, where the interest and repayment amount at maturity are known in advance. Thus, the investor knows right from the time of subscription the expected return on maturity.

A transparency is another advantage of this type of product, since the ratings published by financial rating agencies, as well as the rate of return required by the market for a given issuer, allow investors to assess the credit risk to which they are exposed.

Also noteworthy is the big diversity of existing bonds, due to the high number of issuers, yields, maturities and types of repayment, which allows investors to build a portfolio adapted to their strategy and risk profile.

Risks of investing in bonds

Although investing in bonds is a normally safe type of investment, there are, however, some relevant risks that you should be aware of when investing in bonds, namely:

  • Interest rate riskwhich affects the value of bonds;
  • Credit riskas reimbursement depends on the issuer’s ability to meet its obligations;
  • Liquidity risk: that is, inability to sell the bonds if you intend to dispose of them at a certain point in time.
  • market risk linked to the variation in the price of the bond in the secondary market.

Also read: Bonds, stocks and money. How heavy should they be in your wallet?

Finanças pessoais,Investimentos
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