Fixed Income – Understanding Bonds
What is a Bond?
A bond is a loan taken out by a government or company when money is needed to fund its operations. Since the loan amount for a given issuance is typically large, it is broken down into smaller units or bonds and sold to multiple buyers.
To persuade investors to buy these bonds, the government or company may promise to pay a fixed interest rate over a specified period of time and then repay the outstanding principal amount when the bond matures.
Bond Market Essentials
Every bond has five key elements: maturity date, principal, coupon, yield, price, and rating.
For fixed-rate bonds, the first three listed features will (mostly) stay the same:
(1) Maturity – The date on which the bond expires. Bonds are issued for periods from as little as one year up to 30 years.
(2) Principal – This is the amount due to be repaid in full when the bond reaches maturity. Also known as the face value or par value.
(3) Coupon – Regular interest payments. These may be paid monthly, quarterly, semi-annually, or annually. Not all bonds pay coupons however. A zero-coupon bond does not make periodic interest payments but rather is priced at a discount to the face value.
Example: In 2024, an investor buys a newly issued 10-year government bond with a face value of $1,000 and a yield of 4%. They will receive coupon payments of $40 (1,000 x 4%) every year until the maturity date of 2034, when they will receive their $1,000 principal back. Over the bond's life, they will have invested $1,000 and earned a return of $400.
If an investor buys a bond when it is issued and holds it until maturity, no further action is required by that person. However, for investors who buy existing bonds, two other factors will change and affect their value.
(4) Price – The market price investors are willing to pay for a bond depends on several factors, including interest rates, market supply, the perceived credit quality of the issuer, and the time until maturity. For example, if market interest rates fall below the coupon rate, the bond will be a more attractive investment, and its price may rise.
(5) Yield – This is the return an investor can expect from the bond. A commonly used yield measure (yield to maturity) is the rate of return when discounting the face value to arrive at the market price. Therefore, if the price increases, the bond yield declines, and vice versa.
What does a Bond Rating Mean?
To help investors gauge the level of risk, most bonds are assigned ratings by specialist agencies. A rating between AAA+ and BBB- (or Aaa1 and Baa3, depending on the agency) is considered ‘investment grade’ – a medium to high quality investment with a relatively low level of expected default risk. At BB+ (or Ba1) or below, bonds are considered ‘speculative’ or ‘non-investment grade’, carrying a greater risk of default but generally also higher return potential. You may also see these issues being referred to as ‘high yield’ or ‘junk’ bonds. Ratings agencies may alter the rating if they determine the level of risk has changed.
As with other investments, there is a trade-off between risk and return. Bonds issued by the governments of the US or Germany, for example, have relatively low risk and high ratings, so investors may accept a lower coupon in return for greater security. On the other hand, a technology company with irregular cashflows would likely present a higher risk of default and therefore need to attract investors with a higher coupon.
What are the Different Types of Bonds?
Bonds issued by governments (local, state or national) and companies come in different varieties and have varying characteristics. Here are a few examples:
Convertible: A hybrid corporate bond offering fixed interest payments and the ability to convert the bond into company stock.
Callable: Bonds that give the issuer the right to redeem them (i.e. make full repayment) after a set period, before the bond would mature otherwise.
Floating rate: Bonds that don’t have a fixed coupon but pay interest at a rate that is linked to prevailing short-term rates.
Zero-coupon: These bonds pay no coupon, rather they are sold at a discount to par value.
Green: A rapidly emerging class of bond issued by governments or businesses to raise funds for environmental or climate-related projects.
The Benefits and Risks of Bonds
Benefits:
Income: Bonds offer investors a potentially secure and predictable return.
Stability: Relative to stocks and most other assets, the volatility of bonds tends to be lower.
Diversification: High-quality bonds are viewed as a way to provide balance against the ‘growth’ or ‘risk’ allocations in an investment portfolio.
Risks:
Credit/default risk: Companies and governments can run into trouble. When this happens, the price of their bonds may drop. In the case of a significant crisis or bankruptcy, both types of issuers may default on their payments.
Interest rate risk: If market interest rates rise above the level of bond coupon payments, the value of fixed-rate bonds is likely to decline. In this scenario, floating rate bonds are much less exposed to the same risk, as coupons would increase with rising short term rates.
Inflation risk: In an environment of high inflation, the interest payments on a bond may not keep pace with the decline in purchasing power, resulting in a low or negative inflation-adjusted (real) return.