BondsA bond is a debt security. When you buy bonds you lend money to governments, municipalities, corporations and other issuers from different countries. The issuer is obliged to pay interest (the coupon) throughout the term of the bond and repay the principal (the par value of the bond) at a later date termed maturity.
The most widely known bonds are U.S. government bonds and bonds issued by G-7 governments (the most advanced nations of the world) and the world’s largest corporations.
What is so attractive about bonds?
By investing in bonds an investor chooses reliability and predictability. Bonds normally have a strict coupon payment schedule and a fixed maturity date, which makes it possible for an investor to plan his income with sufficient precision. When forming an individual investment portfolio consisting of different types of instruments (stocks, risky bonds of developing countries, etc.) bonds are used for maximum protection of the principal amount.
Bonds are good for accumulative investments when an investor gradually builds up his savings, for example, for education of his children, a house or retirement.
Because there are many types of bonds with different risk (and income) levels, an investor can build his investment portfolio according to his financial capacity and personal preferences.
The most important features of bonds
The most important indicators that will help you assess the attractiveness of a bond are as follows:
Maturity date - The date on which the bonds will be redeemed by the issuer at their nominal amount. As a rule most bonds will have a term between 1 day and 30 years, in some cases bonds are issued for 100 years. Depending on their maturities bonds are divided into the following categories:
Short term (maturities up to 4 years);
Medium term (maturities up to 12 years);
Long term (maturities over 12 years).
Terms of redemption - Maturity date is a precise indication of the life of a bond. However, some bonds are structured in a way that can seriously affect that term.
Call provisions - Some bonds have a provision, which gives the issuer the right to repay the bond before maturity at par on a certain date (call dates). Normally, this option is used when current interest rates are much lower than they were at the moment when the bond was issued.
Before buying a bond you should check if it has call provisions, and if it does you should verify that your yield in case of early redemption will not be lower than usual. Normally, these would be high-yield bonds, which offer a higher yield per annum than usually as compensation for risk and possible losses that an investor may have to face in case of early redemption.
Puts - Some bonds may have a provision that gives the investor the right to force the issuer to repay the bond before the maturity date after a specified period of time.
Usually an investor would exercise this right when he urgently needs cash or when interest rates have significantly grown since he bought the bond and it is more expedient to invest in higher yield instruments now.
Issuer’s credit history - When an investor plans to buy a bond he should look into the issuer’s credit history first, which he should be able to obtain from his investment manager. It is important to know whether the issuer has always strictly followed the coupon payment schedules with previous issues, whether there have been delays in bond repayments, etc.
Credit rating - When one chooses which bonds to invest in credit ratings by leading rating agencies are a great help. Each rating agency conducts and publishes in-depth analytical studies and surveys of issuers’ financial standing and political climate in different countries on ongoing basis, which makes it possible to assess risks associated with potential investments.
The highest ratings are АAA (S&P) and Aaa (Moody's). Bonds having the ВВВ- rating or higher are considered highly reliable („investment grade”), while bonds having the BB+ rating and below are considered high-yield but risky or „non-investment grade”.
Coupons - The interest rate that the issuer pays to the bond holders can be fixed, floating or payable upon maturity. Usually, however, it will be fixed and expressed as percentage payable on the nominal amount of the bond. In that case the holder will normally receive his interest income on a quarterly basis.
Some issuers and investors prefer the yield to be as close to the current market situation as possible. To achieve this floating rate bonds are used, in which case the variable coupon changes from time to time depending on the reference rates of interest such as rates for US Treasury bills.
Some bonds pay no regular interest at all and the whole yield is rolled up to maturity. Such bonds are termed zero-coupon bonds and are sold at a discount to par value, i.e. the investor only pays a certain part of the par value expressed as percentage of par, and the issuer redeems the bond at the par value.
Price - The price you buy bonds at depends on many factors, including the coupon, demand and supply, rating, time to maturity, etc. Newly issued bonds are usually sold at par value or close to that. If the price of a bond is above par it is called trading at a premium. If the price is below par it is called trading at a discount.
Yield - Yield is your actual income, taking account of the price you have paid for the bond and the interest you have received. There are two basic yield measures: current yield and yield to maturity. Current yield reflects the actual yield from your investment expressed in percentage per annum and depends on the price of the bond and accrued interest income.
Yield to maturity is also expressed in percentage per annum and reflects the yield you will get if you hold your bond to maturity. It is important to take these measures into consideration if your portfolio consists of various bonds with different maturity dates and different yield sizes.
Market fluctuations: how price is linked to yield
During the term of a bond its price may change depending on market situation or the issuer’s credit rating, which will affect the current yield of the bond. When interest rates rise the market price of previously issued bonds decreases, because bonds issued at a later date offer higher yield and investors tend to sell less profitable bonds to buy the ones with higher yields.
When interest rates fall the market price of previously issued bonds, on the contrary, grows, because bonds issued at a later date would offer lower yield. Therefore in case of market fluctuations the income of an investor who sells bonds before maturity can be either higher or lower than yield to maturity.
How yield is linked to maturity date
The more time there is to maturity the higher the risk that interest rates may change in the future, therefore long term bonds offer higher yield than short term bonds in order to offset the investor’s future interest rate risk.
As a rule, bond markets are closely related to the situation in the global economy or in relevant local economies.
The current market price of bonds and therefore their yield can be affected by such indicators as economic growth rate, inflation, indices of employment and a multitude of other indicators, therefore before investing your money in bonds you should seek advice from your investment manager.