If the market was a racetrack, bonds would be the contender for a consolation prize – they‘ll last the race, but everyone knows they’ll cross the finish line long after the winner does. And the numbers support this because the historical returns on stocks have always outperformed bonds.
On the other hand, bonds definitely beat almost any other type of asset when it comes to risk. But, let’s not get ahead of ourselves and start from the beginning.
To give you a good understanding of bonds, we will start with a review of bond basics along with common bond terms used by investors on a daily basis. Then, we will take a look at the special features that affect the value of bonds and how all that comes into play when bonds are traded.
So, what is a bond?
A bond is a loan to a government (or corporation) by an investor. The debtor agrees to pay interest to the bondholder until the repayment date, when the investor is entitled to receive their money back. In a sense, this is very similar to taking a loan from a bank. The differences are that the investor is the bank, and the principal is not paid back in monthly installments; rather, it’s paid in total once the bond repayment is due (also known as bond maturity).
It’s a typical IOU (I owe you) contract, even though the roles might seem reversed. As individuals, we are used to taking loans from lending institutions when we don’t have enough money to satisfy a need or to meet financial goals. Bonds are kind of similar, only on a macro level. With them, governments can borrow from the people in much the same way we as individuals can get credit from banks, which allows them to spend more than they have.
In the case of corporations, they usually issue bonds for big projects. The money can be used to fund research, to recruit new employees for skilled labor, to acquire a new property, or to buy equipment – in essence, to expand business operations, in whatever form the management sees fit. Often, the amounts exceed what a bank would be willing to lend to these corporations, so they turn to the public and offer all sorts of perks in order to motivate investors to hand over some capital for a while.
Governments face different kinds of problems regarding the fresh flow of money. Ideally, when they issue a bond, the money goes for large infrastructure projects like bridges, roads, schools, or hospitals, which are important on a municipal or national level. However, authorities also need to raise money for servicing complex budgetary obligations, for purposes such as refinancing sovereign debt, securing federal spending for national defense, etc.
Bonds as an investment
The incentive for investors to become bondholders lies in the fact that bonds are fairly reliable fixed-income security. In plain terms, the investor gets a fixed interest payment at regular intervals (usually semi-annually) until the principal, or total borrowed amount, is due. As long as the bond issuer is able to meet interest payments and to pay back the principal upon maturity – bonds are very secure investments.
Bonds are designed to be held by the same investor from their issuing until their repayment. In practice, however, bondholders follow alternative investing strategies, so, at one point or another, most bonds actually end up being traded.
But before we delve into the intricacies of trading bonds, let’s take a look at the terms that are used in investment circles to describe the characteristics of bonds.
If you are interested in bonds as investment assets, then you are very likely to hear words like “coupons”, “yield” and “rating” thrown around. It’s how brokerage firms provide details on their offer, and how the projected performance of a given bond is measured. We will review the most relevant definitions below.
As with any other type of loan, the binding terms of the lending agreement are what makes loans attractive to creditors (or in the case of bonds, investors). There are a number of key elements and they all have to be clearly stated. These are the amount to be borrowed (or bond principal), the frequency and the amount of interest payments, and the date by which that loan has to be paid back (also known as maturity date).
However, it gets more technical than that:
Face value – refers to the worth of the bond at the time it has been issued, and this is the amount that is due when the bond matures. Usually, the face value of each bond is $1000. Alternatively, the value of the bond is also known as “par”.
Coupon rate – this term refers to the interest which the bond issuer will pay to the bondholder. It’s calculated on the face value of the bond and is denoted as a percentage. Since the face value is usually $1000, if the coupon rate is 5%, the interest would be $50 (or 5% of 1000) per annum.
Coupon date – is used to express the interval at which interest payments will be made. This date specifies whether the payments will be on a monthly, quarterly, semi-annual or annual basis.
Maturity (date) – the date at which bond issuers are obliged to return the borrowed amount to bondholders. The range is from 1 year to 30 years and it includes short-term, medium-term, and long-term bonds.
Yield – it expresses the rate of return, but it gets more specific than that. Yield to maturity shows the returns if the investor holds on to the bond until maturity. Current yield is the annual income divided by the current price. Yield to call is a somewhat advanced concept that depends on a bond option we will illustrate later.
Duration – though it might sound similar to the maturity date, this term has a particular meaning within investment jargon. Duration expresses the influence of fluctuation in interest rates over the price of a bond. It’s mostly relevant for long-term bonds because they are exposed to bigger risk. Bond duration has an inverse relationship to interest rates.
Rating – it speaks to the credit rating of the bond issuer. Similar to credit scores for individual debtors, a bond issued by a creditworthy debtor will have lower risk or issues with repayment. There are three bond credit rating agencies: Moody’s, Standard & Poor’s, and Fitch.
Types of bonds
There are many different types of bonds on the market, especially if we take foreign bond issuers into account. However, within the US, four general types are considered central and they are labeled according to the institution that is issuing them: government, corporate, agency, and municipal bonds.
This classification also allows us to place bonds with similar characteristics in the same category. Aspects like tax coverage, fixed or variable interest rates, sensitivity to inflation, liquidity of the financial instruments, and expected yield all play a crucial role not only in determining the market price of bonds but also in assessing the risk they carry.
Government bonds are issued by the Federal government through the US Treasury and are also known as US Treasuries. Government bonds are considered to be among the most reliable financial instruments on the market. This is because if the debtor (i.e. the bond issuer) finds meeting coupon rates or repayment of the face value of a bond to be challenging, they have the authority, as a government, to raise taxes in order to cover debt payments.
At the same time, investors in US Treasuries enjoy exemption from state and local taxes, but still pay federal tax on returns. The yields on government bonds are low, however, the returns are up against inflation, or the constant decline in purchasing power.
Those of you that are willing to explore this market will come across the following products:
- Treasury bonds – have long term maturity, between 10 and 30 years;
- Treasury notes – midterm maturity, from 2 to 10 years;
- Treasury bills – short-term maturity of less than one year. Governments don’t pay interest on these bonds; rather, they sell them at a “discounted” rate, and investors get their full value on the repayment date.
- There are two other securities offered by the Treasury that are also prominent:
- TIPS or Treasury Inflation-Protected Securities – their coupon rate moves with the inflation rate to offset losses; and
- STRIPS or Separate Trading of Registered Interest and Principal of Securities – practically separate the coupon payment from the face value payment in order to allow bondholders to trade them independently on the market.
These bonds are issued by Fannie Mae. Keep in mind that this is a government-backed agency. Fannie Mae stands for Federal National Mortgage Association (FNMA) and it finances the mortgage system for low or moderate-income families by offering these bonds (and also stocks). Two other housing-related agencies offer similar bonds: Freddie Mac or Federal Home Loan Mortgage Corporation (FHLMC) and Ginnie Mae or Government National Mortgage Association (GNMA).
They are generally liquid and are some of the most reliable options after government bonds, although they are taxable (sometimes on more than one level). The refinancing of mortgages and the fluctuation of interest rates may have an effect on their value.
States and municipalities issue municipal bonds (even counties can do it). They are also known as “munis” and they stand out with the tax exemptions on returns to investors on a federal, and sometimes on a state level. In a way, munis are tax-free to compensate for their relatively low yield and higher risk, because, although it is rare, local governments can default on their loans.
Large companies issue bonds because, generally speaking, interest rates on bonds are lower than those on bank loans. Also, investors are more inclined to accept higher risks if the bond offers high returns. Corporate bonds are taxable on both federal and local level, so bond issuers need to make their offer attractive. Therefore, investors have to remain vigilant of bond credit ratings of those companies that owe them money.
Distinctive bond features
A lot of creativity is required to do business successfully, and this comes to the fore in times of need. When a company has low bond credit rating, they have to find a way to project trust and raise the capital necessary for maintaining operational capacity. Tailoring high yield features for a bond, or embedding a convertible, call option, or put option can serve to pull fresh money in.
These kinds of gimmicks are done predominantly (but not exclusively) by companies, and they play an important role when bonds are traded. So once we cover this, we will get to some of the most common ways the value of bonds becomes more or less tradeable.
Investment grade bonds vs high yield (junk) Bonds
In a bid to entice investors into corporate bonds, companies that have low credit rating issue debt instruments with high interest rates. The trade-off for such high yield bonds comes in the form of high risk of default. Bonds with these characteristics are called junk bonds and are meant for trading, or to move risk away from the investment portfolio as soon as market opportunity allows that.
Investment grade bonds are on the other end of the risk spectrum. They are issued by companies with high bond credit rating, and higher likelihood of repayment, so they pay low interest rates to bondholders. These are the kind of bonds investors most often get into, to hold them as long as possible, potentially until maturity.
Convertibility rights in a bond
Since corporate bonds already carry higher risk, companies also use their strengths in terms of valuable equity to attract investors. So, they issue convertible bonds, or a bond which can be converted into a stock under certain conditions. Usually, the conditions are that the stock price (per share) has to rise to a predetermined level and then investors can redeem their bonds in equity.
While this offer does allow companies to issue bonds with lower interest rates, at the same time, it hurts investors who got their stocks using regular channels through the stock exchange. In some instances, convertible bonds might be the best option for both bond issuers and bondholders in regards to managing risks.
Callable and puttable bonds
Embedding call and put options into a bond is another eminent way to add versatility to the product. Callable bonds work mostly in favor of the bond issuer because they allow premature repayment of the debt. Why would any company aim to repay their debt faster? Well, this has to do with the fluctuation of interest rates, and the fact that there is an inverse relationship between interest rates and the value of bonds.
If a bond issuer repays their debt before maturation, they will stop paying interest to the bondholder and thus save in the long run. It works the same way as refinancing any other debt. When interest rates drop, the company will pay off the bond and reissue a fresh bond with a lower interest rate. Investors lose in this scenario, because their bonds have just increased in value, but the call option clips their opportunity to profit.
Puttable bonds prioritize the gains of investors. This option allows bondholders to return the bond back to the company before it matures. Usually, this is done if a hike in interest rates is on the horizon and the investors don’t want to hold a bond that will likely lose its value. In essence, they aim to get the principal till the going is good.
If a bond issuer doesn’t pay interest to the bondholder but instead gives a discount to the face value of the bond, that’s a zero-coupon bond. As we mentioned earlier, U.S treasury bills are a typical example of this, but they are not the only zero-coupon bonds on the market. The investor is not robbed of their returns. Rather, once a zero-coupon bond matures, they will get the full par value. The only difference is – investors will not get periodic interest payments but will get the return all at once.
Bonds don’t get much exposure, at least not as much as stocks do. However, the size of the bond market (or its total market capitalization) is bigger than that of the equity market. It has been so in the last two decades, and the trend is here to stay. That means that bondholders are likely to engage in trading bonds and similar fixed income securities. Obviously, not all of them – some investors are into holding bonds to maturity. But for all of the other investors, developing an understanding of how bond pricing works is very important to protect the initial investment. So let’s dive in.
The secondary market
Bonds are traded on the secondary market. This means that when investors trade bonds, they get their bond from a bondholder as opposed to getting them from the original bond issuer. And as in any other market, the price is determined by supply and demand, so bonds can be traded at both a higher or a lower price than the one at which they were bought (from the bond issuer) to begin with.
It’s a typical relationship between a buyer and a seller – a seller offers the product at a certain price and the buyer shows how much they are willing to pay. The selling price is known as ask, while the buying price is known as bid. It’s very similar to the bid/ask spread for stock exchange transactions.
If the bond sells at a price that is higher than its face value (or above par), then the security is traded at a premium. If the bond price is lower than its face value (below par), it’s said that this bond trades at a discount.
What influences bond prices?
There are a lot of factors that influence the pricing of bonds, but the most prominent are:
- time to maturity;
- credit rating of the issuer;
- and market interest rates.
High bond credit rating contributes to low coupon rates, which is great for investors who intend to keep the bond until maturity. These are investment-grade bonds with a low risk of repayment issues. On the other hand, junk bonds have high coupon rates, but – and make sure to keep this in mind – high interest in a bond is an indicator of the low credit rating of its issuer. In other words, it poses a higher risk.
On the front of maturity, investors tend to limit exposure to the effects of long-term inflation. So, short-term bonds, which are less likely to suffer from the loss in purchasing power, are preferred, as long as the yield and coupon rate on the bond is attractive to investors.
When it comes to interest rates, the influence is more profound.
Bonds and interest rates
We have already mentioned that there is an inverse relationship between the price of bonds and interest rates, so it’s fitting to expand on their specific correlation now, as we examine the factors that influence the pricing of bonds.
When interest rates increase, the price of bonds drop, and the other way around. Let’s put this into perspective. If a company issued a bond at a 4% coupon rate and the face value was $1000 back in 2020, but in the meantime, the interest rates have gone up by 0,5%, in 2021 the bonds from that same company are issued with a 4,5% coupon rate to keep up with the fluctuation in interest. Potential bondholders will prefer the bond with a higher coupon rate because it will bring higher returns on investment.
To compensate for the change in interest rates, this company will start offering last year’s bond (2020) at a discount (or face value of less than $1000), so that investors find it as attractive as the bond issued in 2021. If interest rates experience a drop, then that same bond from 2020 can be sold at a premium (or face value higher than $1000).
The bottom line on trading
Investors may find themselves faced with a number of different bond trading offers. Some of them can be quite unique, especially in terms of combining convertibility rights, embedded call (or put) options, current coupon rates, and expected yields. As with any other investment decision, the most important advice would probably be not to follow one isolated bond feature (or indicator of bond performance) when trading. Rather, it’s best to employ comprehensive analysis to come to a decision that is in line with the general financial goals and the risk level each individual investor is comfortable with.
While brokerage accounts are necessary to invest in a bond (either directly from a bond issuer or on the secondary market), there is one alternative that allows investors to delegate much of the heavy lifting to others – by going for a mutual fund or Exchange-traded funds (ETF). Both ETFs and mutual funds charge fees for managing investments, so that is, in essence, the trade-off for distancing yourself from day-to-day tracking of the market when you buy shares in a fund.
Bonds are some of the safest assets to invest in. First, an investor needs to get a bond from a bond issuer with a high bond credit rating who is able to honor the repayment date. And that same bond issuer has to be able to meet periodical interest payments. If the investor holds on to the bond until maturity, and if fluctuations in interest or inflation don’t dent their returns – bonds are a perfect investment vehicle.
When investors don’t want to hold on to the bond until maturity, there are plenty of other investors on the market that would, hence the dynamic trading opportunities. However, bond trading is to be practiced with caution, especially for novice investors.