The Ultimate 101 Guide to Bonds: Everything You Need to Know
The name's Bond. Licenced to Yield
- By investing in bonds, you are lending money (or buying an existing loan made) to the bond issuer in return for an agreed "coupon" (a fixed payment) for a specified period.
- A bond usually involves two types of payment: the return of principal (the face value of the bond, not what you paid for it) when the bond "matures", i.e. when the principal is supposed to be paid back in full, and coupon payments throughout the life of the bond (known as "fixed-income investments" because the coupon is fixed at issue and doesn't change).
- The main risks to investing in bonds include a rise in interest rates lowering the market value of bonds, issuer default and inflation exceeding coupon rates. The bond price goes down when interest rates rise and vice versa!
What Are Bonds?
Bonds are debt instruments that act like an IOU in financial markets. The buyer of a bond is lending money to the bond's issuer. Usually, this is in return for a fixed stream of payments (coupons), which with the purchase price earns the buyer a rate of interest.
Why Are Bonds Issued?
Issuing bonds is similar to taking out a loan, except the issuer borrows money from investors, not banks. When governments wish to borrow money, they often do so by issuing bonds. Companies do this, too, for funding things such as investments or takeovers.
Who Purchases Bonds?
Most bond investors are banks (investing either for themselves or their customers), insurance companies and pension/investment funds. The average investor can invest in bonds, too, usually via a broker. Government bond original sales (or issuance) are through primary auctions. Most bonds can be sold through banks/brokers or, sometimes, secondary markets such as the New York Stock Exchange.
Most bonds involve two types of payments to the investor:
- The principal payment when the bond ‘matures’, known as the bond’s ‘face’ or ‘par’ value.
- A regular income stream, known as a coupon, throughout the bond’s life at fixed intervals. Usually, these coupon payments are based on a fixed percentage of the face value.
Repayment of principal and coupon payments isn’t the only way to make money from owning a bond. You could make capital gains if the bond’s price is higher at the time you sell it than when you bought it.
How Are Bonds Purchased?
If you want exposure to bonds, the most common method is investing in dedicated bond funds or as part of a ‘balanced’ fund.
Bond Funds/Exchange Traded Funds (ETFs)
These are easier ways to own bonds than directly investing in all the bonds held in a fund. By choosing to invest in a bond fund, your money is going into a professionally-managed portfolio of bonds. Because your funds are professionally managed, the fund manager will select the bonds making up the fund on your behalf. The bonds held in such funds are not always held until maturity but are often traded on the secondary market to (hopefully) secure a profit for the fund’s investors.
Regarding choice, you can choose from domestic, international and sector-based funds and ETFs.
Benefits of a Bond Fund
Bond funds are simply more convenient. Many investors do not have the time (or the ability) to analyse the factors determining a bond's price (i.e. macroeconomic and industry/company news and developments). Saving time and energy by choosing a bond fund makes sense.
Bonds as Part of a Balanced Fund
Another popular way of gaining exposure to bonds is to invest in a balanced fund, also known as an asset allocation fund, which is a type of mutual fund (or unit trust) that usually contains a blend of stocks and bonds.
What Is a Mutual Fund?💰
A mutual fund, also known as a unit trust, is an open-ended vehicle that allows investors to pool their money together to purchase a range of securities, such as shares, bonds, and other financial products.
A balanced fund typically has a specified make-up of stocks and bonds; for example, 60% stocks and 40% bonds. Balanced funds make it easy for investors to diversify without needing a massive sum of money, plus there are no complex decisions to make or paperwork to deal with.
Should I Buy Bonds?
Bonds should be a consideration for anybody looking for a regular income stream as part of a diversified portfolio.
There is no one-size-fits-all approach to bonds. You should assess whether you are suited for them in the context of the two investing considerations, risk and return.
Most bonds fall under the low-risk category of the investment risk pyramid. This means that they are the type of investment that could be an important part of your overall investment portfolio.
Finally, make sure that you understand the terms and conditions of the bond!
Bonds Don’t All Pay the Same Coupon
A coupon is a fixed income paid to the bondholder by the bond issuer at specified intervals. A coupon is expressed as a percentage of the principal amount.
The coupon an issuer has to pay on its bond varies depending on the issuer’s credit quality and credit rating:
The general rule of thumb for bonds is that the higher the credit quality of the issuer, the lower the coupon rate on the bond. The reasoning is that an issuer with a high credit quality reflects a low chance of default, making it a low-risk investment and resulting in less reward (i.e. coupon and yield to maturity) for investors. The credit rating is a useful guide to the credit quality of an issuer.
Most bonds issuers, plus bonds themselves, are given a credit rating by a credit rating agency. The credit rating of the bond itself may differ from the credit rating given to the issuing company or country. Generally, corporate bond ratings cannot be higher than the sovereign bonds of the issuer's country.
Any bond that has no rating is known as an unrated bond. This may happen if the issuer believes their targeted investor audience is very familiar with them and is therefore likely to deem their creditworthiness higher than a bond rating agency would.
There is no single centralised bond rating agency, with multiple ones available. The three main ones are Moody’s, Standard & Poor’s (S&P) and Fitch. The bond issuers themselves are the ones who pay these rating agencies to rate their bonds, but it is not a conflict of interest. It's in the interests of both parties (issuer and rating agency) to view the agency as impartial. What’s more, they are the only three recognised by the SEC in the US.
A bond’s credit rating is given on issuance, is not set in stone and may change following a periodic reevaluation. If a bond issuer's credit rating goes down, they will have to pay higher interest for future issues. Existing investors may lose money based on a lower market price for their bonds, though that would not directly impact the issuer.
Non-investment Grade Bonds
Non-investment grade bonds, also known as high-yield, junk, or speculative bonds, are considered risky investments. There is a higher chance the issuer will default, meaning you may not receive the expected coupons or could even lose all your capital.
Where Do I Buy Bonds?
Either in the primary market, where the bond is created and priced at face value, or through the secondary market via a bank or broker.
How Do I Sell a Bond?
You can either receive the principal at maturity or sell it on the secondary market before maturity (assuming a buyer). Of course, if the issuer of your bond defaults before it reaches maturity, then you may receive nothing.
Also known as a ‘perp’, perpetual securities are bonds with no maturity. Issuers of ‘perps’ will try to make interest payments (known as distributions) forever, regardless of whether the issuer is in profit or not.
Most perps have a call feature, which allows the issuer to redeem the bond after a specified time (e.g. five years after issuance), as per the bond’s call schedule. However, there is no fixed redemption date, meaning you may never get the bond returned as issuers are under no obligation to return the principal.
Investors can only sell perps on the secondary market or if an issuer redeems it using a call feature. The secondary market can be highly illiquid, meaning it may be hard to sell.
Risk and Reward
As with all investments, the greater the risk, the greater the reward. So to reflect the greater risk taken on by investors, perpetual securities offer greater yields than more ‘normal’ bonds.
Reasons to Invest in Bonds
1. Fixed Income
Most bonds guarantee a stream of income throughout their life (as long as the issuer is financially sound). Fixed coupon payments could allow you to better forecast your returns compared to investments with variable returns, like shares. There are also zero-coupon bonds where everything depends on principal repayment at maturity.
2. Your Principal Is Repaid
As long as the bond issuer is financially sound, you’ll receive your principal back at the maturity of the bond. The maturity of a bond varies, ranging from 1 to 30 years, with some stretching out to Infinity and Beyond (known as perpetuals, or perps).
3. A Fall in the Bond’s Open Market Value
If you find yourself in a position where you sell your bond before maturity, you could receive a sum lower than the face value, and lower than the price you originally paid. It just depends on demand and supply for that particular bond at the time (and the bid price your broker is willing to quote you).
4. Legal Protection
A bond’s issuer has to pay bondholders their coupons before they pay any dividends to shareholders. By law, bond issuers are obligated to pay bondholders before paying anything to shareholders if they get into financial trouble. This is known as being "higher up the capital structure", and explains why returns, with lower risks, are typically lower for bonds than for the equivalent shares.
Risks of Investing in Bonds
1. Inflation Risk
There's no guarantee that a regular bond’s coupon will match or beat inflation. For example, in December 2022, US Government 10Y bond yields (3.6%) were below levels of inflation (7.1%), meaning that investors were worsening their purchasing power in buying them.
2. Issuer Default
There is a chance, albeit usually a very slim one, of a bond issuer getting into financial trouble and being unable to pay out a coupon or principal on maturity. The price of a bond reflects the credit quality or likelihood of default of the issuer. Default risk is much higher with junk or high-yield bonds compared to investment-grade bonds.
3. Bonds Market Value
If you find yourself in a position where you sell your bond before maturity, you could receive a sum lower than the maturity value. It just depends on demand and supply at the time.
4. A Rise in Interest Rates
There is an inverse relationship between interest rates and bond prices, meaning an increase in interest rates will lower bond prices. The longer the term of your bond, the more exposed you are to interest rate changes during the life of the bond.
5. Liquidity Risk
Government bonds are easy to sell, but corporate bonds can be a little tricky since they usually get priced off-market by banks/brokers. These banks/brokers hold the bond in "inventory" and are willing to "make a market", meaning they offer both a buying and selling price at the same time for a certain number of bonds, with a "spread" between them. The relatively small size of the market and some lack of transparency also means that bond prices can be volatile.
6. Early Redemption
Some bonds, such as perpetual securities (explained further above), have an early redemption call feature. If the issuer exercises its right to redeem, then you will get the face value paid out and may find yourself sitting on cash and unable to purchase a new bond with as high a coupon or yield, meaning your expected returns decrease.
BONDS 101. COMPLETED. ✅
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