Understanding Bonds

A bond is essentially a loan made by investors to a company or government that needs funds. When you buy a bond, you’re lending money to the issuer, who promises to pay you a fixed interest rate and return your initial investment on a specific date.

Bonds are often called debt securities or fixed interest securities. For example, consider the 2% U.S. Treasury Bond issued in November 2021, set to mature in 2041. If an investor bought $10,000 worth of this bond, they would receive regular interest payments until the bond matures, at which point they’d get their $10,000 back. Bonds are a popular way for governments and companies to raise money while offering a steady income for investors.

Bond Issuers and Titles

The issuer is the organization raising money by issuing the bond, like the U.S. Government. Companies, governments, and even global organizations like the World Bank can issue bonds. The bond title usually tells you who the issuer is and what kind of bond it is.

Issuing Bonds

Bonds can be issued by governments or companies. Governments do it often through specialized agencies, while companies may need corporate finance experts. Bonds are sold at a price, typically based on $100 nominal value. If a bond is issued "at par," it means $100 is sold for $100. In some cases, it may be sold at a discount (less than $100) or a premium (more than $100).

Nominal Value

This is the value of the bond on which interest is paid and what is returned at maturity. If you buy a bond with a nominal value of $10,000, this is the amount used to calculate interest, regardless of what you actually paid for the bond.

Coupons (Interest Payments)

Most bonds have a fixed interest rate, called a coupon. For example, the 2% Treasury Bond 2041 pays 2% interest annually, split into two payments. If you hold $10,000 of the bond, you’ll get $200 in interest each year, split into two $100 payments every six months.

Redemption Date

The redemption or maturity date is when the bond issuer pays back the principal amount. In our example, the U.S. Government would repay $10,000 in 2041. Some bonds can be repaid earlier, or have flexible maturity dates, but most have a fixed date.

Market Value

Bonds can be traded before maturity in the secondary market. Their price can fluctuate based on interest rates and demand. For example, if interest rates rise, bond prices may drop. If you sell a bond before maturity, its market value may be higher or lower than what you paid.

Security and Redemption

Government bonds are usually not secured, meaning there’s no collateral backing them, but the government’s promise to repay. Corporate bonds, however, may offer security through a fixed or floating charge on the company’s assets. This gives investors more protection in case the company struggles financially.

Special Provisions

Some corporate bonds come with "call" or "put" provisions. A call provision allows the issuer to repay the bond early, while a put provision gives investors the right to sell the bond back to the issuer early. These features add flexibility for both the issuer and the investor but come with trade-offs in terms of risk and return.

Classification of Bonds

By Issuer:

• Sovereign Borrowers: Most bonds are issued by governments and supranational organizations (like the World Bank).
• Companies: Corporations also issue bonds.
• Local Government Authorities: These issuers are less common.

By Structure:

• Conventional Bonds: Straightforward bonds without unique features.
• Index-Linked Bonds (ILBs): Coupon payments and redemption amounts adjust for inflation, often called inflation-protected securities.
• Zero-Coupon Bonds (ZCBs): Issued at a discount, these bonds have no coupon payments and provide returns as capital gains upon redemption at par.
• Convertible Bonds: Allow holders to convert them into other bonds or the issuing company's shares on specified terms.
• Floating Rate Notes (FRNs): Bonds with coupons that periodically adjust based on a benchmark rate, such as LIBOR.
• Callable Bonds: Enable the issuer to repay the bond early.
• Putable Bonds: Allow the holder to request early repayment.

By Market:

• Domestic Market: Bonds can be issued in the issuer’s own country.
• International Market: Bonds may also be issued across various international debt markets.

Types of Bonds

Bonds are loans that governments, companies, and sometimes local authorities use to raise money. In this section, we will focus on the different types of bonds issued by governments and companies.

Government Bonds

Governments issue bonds to pay for their spending and investments, especially when their income from taxes isn’t enough. They offer various types of bonds to meet their financial needs. The main types are regular fixed-interest bonds and inflation-protected bonds.

To understand government bonds better, let's look at U.S. government bonds, known as "Treasuries." There are four main types of Treasuries:

Treasury Bills (T-Bills)

• These are short-term loans that the government uses to borrow money for less than a year.
• They usually have maturities of 28, 91, or 182 days.
• T-Bills do not pay interest; instead, they are sold for less than their value and pay the full amount at maturity.
• Once they are sold, they can be traded in the secondary market, where their price is based on their yield to maturity (YTM).

Treasury Notes (T-Notes)

• These are regular government bonds with a fixed interest rate and a set date for repayment.
• They have maturities ranging from two to ten years, commonly issued for two, five, or ten years.

Treasury Bonds (T-Bonds)

• Similar to T-Notes, but these bonds have longer maturities, between ten and 30 years.

Treasury Inflation-Protected Securities (TIPS)

• These bonds are designed to protect against inflation.
• The amount paid back at maturity is adjusted according to changes in the Consumer Price Index (CPI), which measures inflation. Interest payments are also adjusted for inflation and are paid semiannually.

Another type of instrument is known as STRIPs. STRIPs are created by breaking down Treasury notes, bonds, and TIPS into their individual cash flows (each interest payment and the final payment at maturity). Each part is then sold separately as a zero-coupon bond (ZCB). STRIP stands for "Separate Trading of Registered Interest and Principal Securities."

Corporate Bonds

Corporate debt refers to the money that companies borrow and must repay. A corporate bond is a specific type of bond issued by a company to raise funds. Typically, corporate bonds are long-term instruments with maturities of more than 12 months, while shorter-term instruments are called commercial paper (CP). Only companies with strong credit ratings can issue bonds with maturities over ten years at reasonable costs. Most corporate bonds are traded on stock exchanges, but much of the trading occurs in the over-the-counter (OTC) market, meaning transactions happen directly between buyers and sellers.

Types of Corporate Bonds

Medium-Term Notes (MTNs)

• MTNs are standard corporate bonds with maturities ranging from nine months to ten years, though they can extend up to 30 years.
• Unlike other debt instruments that are offered in large batches, MTNs are offered continuously to investors over time through an agent of the issuer.
• This market originated in the U.S. to fill the gap between commercial paper and long-term bonds.

Fixed-Rate Bonds

• Fixed-rate bonds have a consistent interest rate (coupon) that is paid either semiannually or annually on specified dates.

Floating-Rate Notes (FRNs)

• FRNs have variable interest rates linked to a benchmark rate, such as the Secured Overnight Financing Rate (SOFR) in the U.S. This rate reflects the average cost for institutions to borrow dollars overnight while using U.S. Treasury bonds as collateral.
• FRNs typically pay interest at the benchmark rate plus an additional margin or spread.

Convertible Bonds

• Convertible bonds are standard fixed-rate bonds that can be converted into company shares.
• The terms of conversion are set at the time of issuance, and bondholders have specific opportunities to convert their bonds into shares.
• If the conversion option is not used, the bond remains a conventional bond and will be repaid at maturity.

Zero Coupon Bonds (ZCBs)

• ZCBs do not pay interest. Instead, they are issued at a discount to their face value and redeemed at full face value upon maturity.
• The return is generated entirely through capital appreciation rather than through periodic interest payments.

Additional Features of Corporate Bonds

In addition to the type of bond and the issuing company, corporate bonds have important features related to security and redemption.

When companies issue bonds to raise funds, they often provide some form of security to reassure investors about repayment. This security can be a legal claim on the company's assets, such as property or equipment, ensuring that bondholders can recover their investment in case the company defaults. In some cases, a third-party guarantee, such as from a bank, may also be offered, promising to pay bondholders if the issuer fails to do so. Generally, the more security a company offers, the lower the interest rate it will have to pay on the bond.

Most bonds have a fixed redemption date, at which point the bond's face value will be repaid to the bondholders.

Investment Returns from Bonds

The returns from bonds, like those from stocks, come from two main sources: income returns (coupon payments) and capital returns (price changes while holding the bond).

If you buy a bond at its face value (par) and hold it until it matures, your return will consist solely of the coupon payments. However, if you buy the bond for a different price or sell it before maturity, your return will also depend on the difference between your purchase price and the selling price, leading to a capital gain or loss.

In normal conditions, investors expect a positive return. However, there have been times when government bonds offered negative returns, meaning investors received less than their original purchase price upon maturity.

Components of Bond Returns

The total return from a bond includes both the coupon payments received over its life and any capital gain or loss incurred when the bond is sold or redeemed. Yields are commonly used to measure these returns, with two main types being flat yields and yield to maturity (YTM).

Flat Yields

The coupon on a bond represents the interest rate applied to its face value (the nominal or principal amount). However, since investors may purchase the bond for a price different from its face value, we need a way to calculate the actual return on investment.

One straightforward method to determine a bond's return is to calculate its flat yield, also known as the running yield or interest yield. The flat yield expresses the coupon payment as a percentage of the bond's current market price (known as the clean price). The clean price excludes any interest that has accrued since the last coupon payment, while the dirty price includes this accrued interest.

Examples 1: XYZ plc Bond

• Coupon Rate: 5%
• Maturity Year: 2030
• Current Price: $100 (per $100 nominal value)

Example 2: ABC plc Bond

• Coupon Rate: 4%
• Maturity Year: 2035
• Current Price: $78 (per $100 nominal value)

Yield to Maturity (YTM)

The flat yield only considers the bond's coupon payments and ignores the difference between the bond’s current market price and its maturity value. To provide a more complete picture of a bond's return, we use the Yield to Maturity (YTM). This measure, also known as the Gross Redemption Yield (GRY) or yield to redemption, combines the flat yield with any capital gains or losses that occur if the bond is held until maturity. This gives an average annual return.

For instance, consider a 2% US Treasury Bond maturing in 2041 that is currently priced at $78.12. The YTM for this bond will be higher than the flat yield because the market price is below the bond’s face value, meaning the bondholder will realize a capital gain when the bond matures. Conversely, if the bond's market price were above par, the YTM would be lower than the flat yield since the bondholder would incur a capital loss at maturity.

YTM provides a more accurate measure of the total return an investor can expect and allows for comparison between different bonds to determine which offers the best return.

While the formula for calculating YTM can be complex, a simplified approach is as follows:

It's important to note that this method yields only an approximate estimate of the YTM.

To illustrate the value of YTM, consider the following example.

Example Bond: 2% US Treasury Bond maturing in 2041

• Current Market Price: $78.12
• Flat Yield: 2.56%

Maturity Value:

• Upon maturity in 2041, the investor will receive the nominal value of $100.
• This results in a gain since the purchase price is lower.

Misleading Flat Yield:

• Relying solely on the flat yield can mislead investors regarding the actual return.
• It is essential to account for the capital gain to obtain an accurate yield.

Yield to Maturity (YTM) Calculation:

• Assume the bond matures in 19 years.
• Capital Gain: $21.88 (calculated as $100 nominal value - $78.12 current market price).

Annual Gain Calculation:

• Annual Gain = $21.88 ÷ 19 ≈ $1.1516

YTM Result:

• YTM ≈ 4.03%
• This figure gives a more accurate estimate of the investor's total expected return if the bond is held until maturity.

Key Risks of Holding Bonds

• Default Risk: The risk that the issuer may fail to make interest payments or repay the bond's principal.
• Market or Price Risk: Changes in interest rates can significantly impact the value of bond holdings.
• Unanticipated Inflation Risk: The risk that unexpected inflation reduces the real value of both the coupon payments and the final repayment of the bond.
• Liquidity Risk: Some bonds may not be traded frequently, making them hard to sell quickly, or they may have wider-than-average trading spreads.
• Exchange Rate Risk: For bonds denominated in a foreign currency, adverse exchange rate movements can impact returns.

Additional Risks for Corporate Bonds

• Early Redemption Risk: If a bond is callable, the issuer might redeem it before maturity.
• Seniority Risk: The ranking of corporate debt in case the issuer goes bankrupt. Investors holding lower-ranking debt may face higher losses.

Focus on Key Risks

• Market Risk: Although bonds are generally less risky than equities, bond prices are closely tied to interest rates. As interest rates change, bond prices can fluctuate.

Market Risk Explained

Interest Rates and Bond Prices:

• If interest rates rise, bond prices fall because their fixed-rate payments become less attractive.
• If interest rates fall, bond prices increase as their fixed-rate payments become more desirable.

Examples:

• When interest rates increase from 5% to 10%, a bond with a 5% coupon becomes less attractive, and its value drops.
• Conversely, if interest rates drop to 2.5%, the same bond becomes more valuable, increasing its resale price.

Inverse Relationship:

• Rising interest rates lead to lower bond prices.
• Falling interest rates lead to higher bond prices.

Impact of Bond Maturity and Coupon Rate:

• Longer-dated bonds are more sensitive to interest rate changes than shorter-dated bonds.
• Bonds with lower coupon rates are more affected by interest rate changes than higher-coupon bonds.

Yield Curve:

• The yield curve shows the relationship between bond yields and the time until they mature.
• In normal circumstances, the yield curve slopes upward, meaning longer-term bonds offer higher yields to compensate for additional risk.

Default Risk

• Credit Risk: Refers to the possibility that an issuer may not meet its financial obligations.
• Default Risk: A subset of credit risk where the issuer fails to make scheduled payments or violates the bond’s terms.

Credit Ratings:

• Independent agencies like Moody’s, Standard & Poor’s (S&P), and Fitch rate the creditworthiness of bonds.
• Ratings range from AAA (highest quality) to D (in default).

Categories of Credit Ratings:

• Investment Grade:AAA, AA, A, and BBB ratings are considered safe and stable.

Non-Investment Grade (Junk Bonds):

• Ratings below BBB (Ba, BB, B, etc.) are speculative and carry higher risk.

Rating Refinements:

• S&P and Fitch add "+" or "-" to refine ratings.
• Moody’s uses numbers like 1, 2, or 3 to indicate relative ranking within a rating category.

Only a few organizations, primarily supranational agencies and some Western governments, receive a triple-A credit rating. However, most large corporations typically have bond issues that fall within the investment-grade categories.

Stay tuned for more articles on the financial markets.