Analysis of Asset Allocation

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Bonds - An Introduction
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DEFINITION

Unlike equities that represent a participation in a company, a bond is a debt security. When you purchase a bond, you lend money to the issuer of the bond. The issuer can be a government, a municipality, a federal agency, a corporation or another entity. A bond has generally a maturity (a date at which the issuer reimburse the amount borrowed) and an interest payment.

The stream of payments linked to a bond is known in advance (provided that the issuer can pay) but this stream depends of the bond. You have bonds that pay a fixed interest during the life of the paper (fixed rate bonds),  you have others that pay a revised interest rate (floating rate bonds) or even no interest at all (zero coupon bond).

All these key variables will be studied in the section 'bonds characteristics'.

WHY INVESTING IN BONDS?

Most of the professional advisors recommend that  investors hold a diversified portfolio made of bonds, stocks and cash in varying percentage depending upon their risk awareness. Very prudent investors will have a huge proportion of their assets in cash, kamikaze investors will have only equities or even derivatives.

Because bonds have a predictable stream of payments, they are considered as less volatile than equities and consequently less risky.

All depends of the bond in itself. In the next section we will study the main characteristics of the bonds that can have an influence on the price volatility  and the risk profile.

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