Bonds are often seen as the opposite end of the investing spectrum to Stocks, but what exactly are they? In this post we will delve into the mechanics of bonds and why they should have a place in your portfolio.
What are Bonds?
Investopedia defines a bond as “a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental)”. A bond is essentially an IOU. It is a debt instrument with the borrower known as the issuer and the lender known as the holder.
Unlike stocks, bonds do not grant the holder any entitlement to the ownership or profits of the issuer. For a layperson, the easiest way to think of a bond is the reverse of a loan you may receive from the bank. Rather than paying the bank interest for the use of their capital, you receive interest for the use of your capital. The term fixed income is important, bonds offer a source of income on a predefined basis, usually twice a year or quarterly.
Components of a Bond
At its most basic the issuer of the bond agrees to pay the bondholder a set interest rate over a set period while also returning the principal amount at the end of the term. Bonds can be bought and held until maturity but they can also be bought an sold on the open market. A bond is made of various elements that combine to form to the overall structure of the bond.
- Issue Price: The amount the issuer sells the bond initially.
- Principal: The amount that the bond is worth at maturity.
- Coupon Rate: The interest rate associated with the blond. It is usually a fixed rate based on the principal amount. I.e a €100 bond with a 10% coupon rate will pay €10 per year until maturity.
- Coupon Dates: The dates on which the interest will be paid, usually semi-annually.
- Maturity Date: The day on which the issuer will repay the principal amount to the bondholder.
- Market Price: The amount the bond currently sells for in the market. Market prices of a bond can fluctuate based on current market conditions. If interest rates fall a bond may trade at a premium as the interest rate locked in on the bond is higher than can be attained at current rates. Likewise, if interest rates rise bond prices can fall as bonds with a lower coupon rate become less desirable.
- Yield: The rate of return received from buying the bond. The yield is clearly outlined on the initial bond sale but may vary as the market price of the bond does.
The returns you can expect from any individual bond will vary according to the specifics of the above elements.
Who issues Bonds?
Bonds can be issued by a variety of institutions and typically the risk associated with the bond is dependant on the issuer. Bonds are usually issued by the following entities:
- Government Bonds: These are issued by governments across the world. They are typically seen as the lowest risk category of bonds. As a result, the coupon rate tends to be lower.
- Corporate Bonds: These are issued by companies who need capital but do not want to issue stock or get a bank loan. Bonds usually have more favorable payment terms to business loans. Companies are graded by financial institutions. Based on the rating bonds can vary from investment-grade down to junk bonds. The coupon rate is inversely correlated to the credit rating, the higher the rating the lower the coupon rate and vice versa.
- Municipal Bonds: Issued by states and municipalities in the USA, some being tax-free.
- Agency Bonds: Also issued in the USA, by agencies affiliated with the government.
Types of Bonds
Wikipedia lists 29 different types of bonds. Needless to say, there is little point listing them all here. For now, I will cover the main types of bonds you will see in the market. As with stocks, it is important to know what type of bond you are investing in before you buy it. Much like stocks, some bonds can be bought back or sold back to the issuer.
Zero-Coupon Bond: Don’t pay interest in the typical fashion that regular bonds do. Rather than paying a semi-annual coupon, the bonds are sold at a discount to the premium. This results in the interest being effectively rolled up and paid at the end of the maturity.
- Callable Bonds: A callable bond is similar to a redeemable share. The issuer has the option to “call” the bond and buy it back before the maturity date. This is an attractive option for the issuer of the bond as it protects them from falling interest rates. Say a company issues a bond with a coupon rate of 8% and a maturity of 10 years, if in 4 years the interest rate has fallen to 6% they may call the bond back by repaying the principal. They will then re-issue a bond at a lower coupon rate. Conversely, it is not as attractive an option for the holder of the bond. As interest rates fall, bonds become more valuable so there is a risk of losing a bond that is rising in value.
- Putable Bonds: A putable bond is essentially the opposite of a callable bond. With a putable bond, the holder has an option to sell the bond back to the issuer before the maturity date. Putable bonds are typically more attractive for bondholders as they can protect them from rising interest rates. If interest rates rise while a bondholder owns a bond, they are locked into a lower interest rate. A putable bond solves this problem.
- Convertible Bond: A convertible bond has an option to convert the debt into equity (stock) at a certain point, depending on various factors. Convertible bonds can be an attractive option for both the issuer and the holder. A company may issue a convertible bond at a lower coupon rate than a regular bond, with the stipulation that the holder can convert the debt into shares if the share price reaches a certain point. This is attractive for the company as they pay a lower interest rate, and it can be attractive for the holder if the share price is on an upward trajectory. A convertible bond holds some risk for an investor as the specified share price may never be reached, resulting in them holding a bond with a low coupon rate.
The above types are just a guide. Bonds can contain various options and are often uniquely structured. It is important to do your research and understand the structure of the bond before you buy it. Alternatively, you can invest in a bond fund that owns various bonds. Funds will be discussed in a later post.
How are Bonds Priced?
This post so far has focused on the mechanics of a bond and we have assumed that the holders will hold the bond to maturity. This is not always the case. Bondholders may choose to sell their bonds on the open market. This section will cover the pricing of bonds on the open market.
The price payable for a bond on the open market is determined by several factors. Firstly, supply and demand an impact on the price of a bond. The main factor that impacts the price of a bond is something we have touched on previously; interest rates. Short term government bonds are usually used as the benchmark for interest rates, so we will use them as a comparison in the example. For this example, two terms are important, premium, and discount. If the current price of the bond is above the principal value the bond is trading at a premium. If the current price is lower than the principal value it is trading at a discount.
If a bondholder is in possession of a 10 year bond with a principal value of €1000 (let’s keep it simple) and a coupon rate of 10%, they will receive €100 per year. Assuming the short term interest rate at the time of issue was also 10%, the bond is delivering the same return as a short term government bond. But what happens if the interest rate falls? The bond is now much more attractive than the government bond. As it is a more attractive investment, the price rises and will find an equilibrium based on the current interest rate. In our example, if the interest rate has fallen to 6% the bond prie will stabilize at €1,666.67. The bond is now trading at a premium.
Interest Rate 10%
- Principal = €1,000 (Serves as market price initially)
- Coupon Rate = 10%
- Yield = 10%
Interest Rate 6%
- Principal= €1,000
- Coupon Rate = 10%
- Market Price = €1,666.67
- Yield = 6%
As you can see, the yield of the bond will match the underlying interest rate. Generally, the coupon rate will not change during the life of a bond. In order for the bond market to reflect the current interest rates, the price must fluctuate to ensure the bond returns are the same as the interest rate. This is why bonds are usually inversely related to the interest rate. As the interest rate rises, bond prices fall and vice-versa.
If the interest rate in the above example were to rise to 12%, the price of the bond would fall to allow the yield to reflect the interest rate.
Interest Rate 12%
- Principal = €1,000
- Coupon Rate = 10%
- Market Price = €833.33
- Yield = 12%
An important point to note is as a bond approaches maturity, the market value will approach the principal value. It is perfectly rational. If you have two identical bonds and one has a maturity of 3 years while the other has a maturity of 5 years, the 3-year bond will be closer to the principal value. This is due to the fact that there will be fewer interest payments paid on the 3-year bond in comparison to the 5-year bond.
Why Should You Invest in Bonds?
Bonds are a fantastic way to diversify your assets. Although stocks and bonds may be correlated (positively or negatively depending on the timeframe you are looking at), they do not act completely in tandem. As such, if you are fully invested in stocks and there is a market crash, bonds can offer you no protection. However, if you have a portion of your assets in bonds and there is a stock market crash, the bond portion of your portfolio will offer you some protection from a complete crash.
Bonds also offer guaranteed income (providing you steer clear of the zero-coupon option). Stocks may or may not pay dividends but a coupon paying bond will always return capital, providing the issuer does not default. Government bonds are also one of the safest places to put your money. The chances of a government defaulting are relatively low, providing you stick to developed stable countries, and besides, if your government defaults I think you will have bigger things to worry about! Many governments also offer tax-free interest payments which can be a huge benefit.
As you can tell from the length of the post above, bonds are a little more complicated than stocks. As a consequence, it is important that you understand the basics before investing in them.
The Stoic Trader