HOW DO SAVINGS BONDS WORK

Institutions like sovereign wealth funds, pension funds, central banks, insurance companies, hedge funds, and other banks are the ones that buy and trade Bonds mostly.

For the pension funds and Insurance companies have liabilities which include fixed amounts payable on set dates. Therefore they buy the bonds to match their liabilities. Sometimes the law may compel them to buy the bonds due to this liabilities. Most individuals who want to own bonds do so through bond funds.

Compared to stocks Bonds have lower volatility hence making bonds safer investments.

RISKS ASSOCIATED WITH SAVINGS BONDS

1)Yield curve risk.

2)volatility risk

3)Interest rate risk, meaning that the market prices will decrease in value when the generally prevailing interest rates rise resulting to an increase in yield of the bond.

4)call and prepayment risk

5)sovereign risk

6)liquidity risk

7)credit risk

8)Reinvestment risk- the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

9)event risk

10)exchange rate risk

11)inflation risk

However some of the above risks affect certain classes of investors only.

Price changes in a bond will immediately affect mutual funds that hold these bonds. If the value of the bonds in their trading portfolio falls, the value of the portfolio also falls. This cause damage to professional investors such as banks, insurance companies, pension funds and asset managers, irrespective of whether the value is marked to market immediately or not).

There is usually a real problem of interest rate risk if there is any need for a holder of individual bonds to sell his bonds and cash out. But there efforts that one can employ to control this risk and they are called immunization or hedging.

A person or institution contemplating on opening a savings bond account should beware of the following things:

A)Bond prices can become volatile depending on the credit rating of the issuer

B)A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries, bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. However there is no guarantee of how much money will remain to repay bondholders.

C)Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This is what creates reinvestment risk, meaning

D)Bonds are often liquid and with certainty of a fixed interest payment twice a year and a fixed lump sum at maturity is attractive.

E)Bondholders enjoy legal protection where under the law of most countries, if a company goes bankrupt, its bondholders will often receive the recovery amount back.