What is a Bond?
A bond is a financial instrument that is usually issued by governments and corporations. It can offer a steady stream of income to investors over time. A bond gives the opportunity to investors to lend money to these institutions and is typically a long-term investment. Funds raised from the issued bonds can later be used by governments and corporations to invest in new projects and finance government spending.
In order to understand how a bond works, let’s explore the payment structure by defining the bond’s key variables.
- Principal amount (face value): The amount of money that the bond’s issuer promises to pay the investor at maturity.
- Coupon rate: The percentage rate of the bond’s principal amount that the bond’s issuer promises to pay the investor according to the coupon frequency.
- Coupon frequency: The frequency of the coupons that the bond’s issuer is going to pay the investor. This is usually on an annual, semi-annual or quarterly basis.
- Maturity: The length of the bond in years. At the maturity date, the bond’s issuer promises to pay the investor the principal amount and the last coupon.
For example, suppose I want to invest in a crowdfunding company issuing a 10-year (maturity), annual (coupon frequency), 5% (coupon rate), and €10,000 (principal amount) bond. The price I will pay upfront to invest in this bond will be something close to €10,000 (will explore bond pricing later in the article). The crowdfunding company that issued this bond promises to pay me €500 (=5% * €10,000) every year from Year 1 to Year 10, and €10,000 in Year 10. I will receive these payments as long as the company does not go bankrupt any time before the bond’s maturity date.
Why do Governments and Corporations issue Bonds?
Governments use the money borrowed from issued bonds to finance various public investments such as hospitals, schools and public transportation projects. Issuance of government bonds is historically higher when tax revenues are considerably lower than government spending.
Furthermore, corporations borrow money from investors to grow their business, invest in research and development and buy equipment that allows them to work on different projects more efficiently and effectively.
Types of Bonds
Government Bonds are considered to be the safest type of investment among the different bond types. They are issued by governments with the target of funding government activities. These activities might include financing government spending and investment planning to complement funds raised from taxes. A government bond is considered to be a relatively risk-free investment, as governments have the power to raise taxes to pay back their debt, which makes them more likely to deliver on their promised payments. This level of safety equates to an extremely low risk of default, although there can be exceptions. As previously discussed in our Risk-Return Principle lesson, an investment’s level of risk often determines the level of reward for the investor. This type of bond offers to pay back a very low-interest rate (very close to the risk-free rate depending on the government issuing the bond) to the investor, as the level of risk is usually extremely low.
Municipal Bonds are issued by states and municipalities rather than governments. They are considered to be a safe investment as the issuer of these bonds also has the ability to raise funds through taxation. However, municipal bonds are not as safe as most government bonds, and there is a slightly higher probability of issuer default. Their yields (coupon rates) are usually low due to their low level of risk, in addition to them being free from federal income tax and state tax in the state in which they are issued.
Corporate Bonds are typically issued by large companies. They are also considered a relatively safe investment. However, in the past, we have seen many large companies attempt to issue debt in the form of bonds and then fail to pay back their lenders/investors. We call this risk of default. Therefore, the higher level of risk associated with corporate bonds is often accompanied by a higher interest rate compared to government bonds. Higher potential returns can make this type of bond attractive to investors.
High Yield Bonds or Junk Bonds are issued by relatively new companies that are looking to raise funds to invest in new projects and their development. High-yield bonds usually offer higher interest rates to investors compared to the other bond types above, as younger companies often face a higher risk of default. The payoff for the investors that are interested in this type of bond can be high, assuming that the companies survive the test of time. Therefore, even if the level of risk associated with high yield bonds is relatively high, the promised coupon rate is higher as well to compensate for the higher level of risk the investor takes.
Bonds’ Credit Ratings
Credit Rating Agencies (CRAs) such as Fitch, Moody’s and S&P are responsible for rating the different types of Bonds. Based on the bond’s level of risk, CRAs will give a rating to that bond. The credit rating of a bond depends on many factors, including and not limited to the issuer’s credit quality, the coupon rate, the length to maturity, and the bond’s seniority.
The rating given will help investors decide if a specific bond fits their investing profile with regard to risk appetite. It is important to mention that CRAs have at times been inaccurate with their assessment of bonds and their level of risk, which was one of the many reasons for the Great Recession of 2008. Therefore, it is critical for investors not to take these ratings as absolute but instead performs their own research before deciding where to invest their money.
In the event that a bond’s issuer goes bankrupt, the more senior bonds will be able to recover their losses first before less senior bonds regain any lost value. Again, based on the risk-return principle, the more senior bonds offer more security and are considered a safer investment than less senior bonds. However, the latter offers a higher return (higher interest rate) as the level of risk is also higher.
Before explaining how a bond is priced, it is important to understand where bonds are traded. You can invest in a bond in the primary market, which means your money goes directly to the issuer. Or, you can invest in a bond in the secondary market, which means you are buying a bond from someone else other than the issuer, usually another investor or a dealer. The secondary market makes it possible to trade bonds long after the issuance date, essentially meaning that you don’t always have to keep the bond until its maturity.
So, as we saw before, we have the bond’s face value, its coupon rate and frequency, as well as its maturity. With this information, we can calculate the exact promised payments from issuance until maturity. We discount every payment to its present value, and that should give us the bond’s price. However, the interest rate used to discount each payment is highly subjective and depends on many factors. These factors are also the ones used by the CRAs to produce their ratings. What you usually want to do is find the credit rating of the bond’s issuance (if CRAs rated the specific bond) or the credit rating of a similar bond, and that will give you a good indication of the interest rate to use to discount the bond’s payments to find its price.
For publicly traded bonds, we often see their price change on a daily basis. Forces that can cause these fluctuations in prices are supply and demand. For example, when demand for a particular bond increases, the bond’s price will go up. However, from the time a bond is issued, the promised payments are exact; they do not change. So why are investors willing to pay more money today than yesterday for the same payments? This can happen for a multitude of reasons, with market interest rate changes usually being the main one. A lower interest rate environment (like the one we’ve been in for quite some time now) can decrease demand for government bonds as investors turn to corporate bonds where promised interest payments are higher.
Bonds with Options
Some bonds include options. These options can be in the favor of the issuer or the investors. Let’s explore the three main types of bonds with embedded options.
- Callable bond: Gives the issuer the option to redeem the bond earlier than the maturity date. The bond’s documentation will include specified dates before maturity on which the issuer will have the option to pay the bond’s outstanding amount to investors. An issuer might be inclined to do that when it is beneficial for them, usually when interest rates drop. If interest rates drop, the issuer can issue a new bond with a lower coupon payment and use the proceeds from the new bond’s issuance to repay investors from the old bond. As this option favours the issuer, its price is lower than an otherwise identical bond without the option.
- Putable bond: Gives the investor the option to sell the bond back to the issuer earlier than the maturity date. The bond’s documentation will include specified dates before maturity on which the investor will have the option to force the issuer to pay them back any outstanding amount of the bond. The repurchase price is set at issuance and is usually close to the principal amount. Investors can exercise their options when it is beneficial for them, usually when interest rates rise. If interest rates rise, the investor can exercise their option to receive the money earlier than maturity and use the proceeds to invest in a new bond issuance where the coupon rates will be higher due to the rising interest rate environment. As this option favours the investor, its price is higher than an otherwise identical bond without the option.
- Convertible bond: Gives the investor the option to convert the bond into common stock of the issuing corporation. The bond’s documentation will include specified dates before maturity on which the investor will have the option to convert their debt in a corporation into a specified number of shares based on the agreed conversion price. An investor can exercise their option when it is beneficial for them, when the value of the shares to be received is higher than the bond’s value. This can happen due to interest rates rising, or the corporation’s equity is more attractive, for example, due to a successful expansion in another geographical area. As this option favours the investor, its price is higher than an otherwise identical bond without the option.
What’s in it for the Investor?
Through the life of the bond, the investor receives a steady stream of income from interest payments being made by the borrower. This allows investors to invest their hard-earned cash in debt and receive it back with interest, usually at higher rates than the bank will offer for savings accounts, while also offering protection against inflation.
Sell for profit
A feature that differentiates a bond from most common loans is that it is tradeable. If the value of a bond is increasing throughout its life, or you need the cash back early due to an unexpected event, you might decide to sell the bond before maturity. While this fact increases the bond’s liquidity, it also allows you to sell it at a premium and make a profit.
We usually find a combination of bonds and stocks in an individual’s portfolio. This allows you to diversify your investments by taking advantage of the low investment risk associated with bonds to satisfy and balance your individual risk appetite.
Payback of initial investment
By holding the bond to maturity, you get back all the principal invested. However, even for the safest of bond investments, there is no 100% guarantee, as the issuer might go bankrupt before the maturity date.