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Getting started with Bond Investing

bond guide

What is a bond?

A bond, better known as a fixed-income instrument, is a fairly simple and straightforward investment whose concept is easy to grasp.

A bond is simply a loan taken out by companies or governments, whereby:

  • Investors lend money to a company in the form of a bond, and are hence called bond-holders.
  • In exchange, the issuing company or government pays interest in the form of a coupon at pre-determined intervals (usually annually or semi-annually) and re-pays the capital on the maturity date. This is also known as the bond redemption date.

So before investing in bonds, an investor already knows:

-       The initial investment he is going to make;

-       The exact amount of interest he is going to receive;

-       The timing and frequency of interest payments (payment dates)

-       The time at which he will receive the original outlay back (maturity date)

How do investors know all this before investing?

If an investor invests €10,000 in a bond maturing on 31st December 2020 that pays a coupon of 7% on 31st December on an annual basis, the investor already knows that he will receive €700 on every 31st December of the year and the bond will be redeemed on 31st December 2020. The investor however may choose to sell the bond at any time during its lifetime.

Watch a 2 minute video about explaining what bonds are here.

How bonds are displayed on Bond lists

When reviewing a list of bonds on a sheet for example, the investor is provided with all the basic information he needs to know.

Also when making an order online for example Bonds are normally displayed in the following format -: 7.625% LLOYDS GROUP 2020 EUR

This means that the company LLOYDS GROUP will pay 7.625% worth of interest each year in EUR until 2020.

Other information can be found in bond sheets, such as the Credit Rating of the bond and the next payment date.

sample bond list

Key Types of Bonds

Sovereign Bonds: Also known as Government Bonds, these bonds are issued by the Government of a particular country.

Corporate Bonds: These are bonds issued by individual companies and corporations.

The Market Price of a Bond

The value of a bond on the secondary market is dictated by the traditional forces of demand and supply are one of the primary determinants of the market price of a bond. However, a factor that has a substantial influence on the price of a bond is the level of prevailing interest rates in the economy.

When interest rates rise, the prices of bonds in the market fall. (this is because new bonds that are issued must be issued at higher interest rates and therefore investors can find better bonds with interest elsewhere.) This however gives an opportunity to bond investors to buy bonds at a lower price.

When interest rates fall, the prices of bonds in the market rise.(this is because the bonds that were already issued with higher interest rates are giving even better interest than new bond issues on the market and therefore demand for these bonds increases). When interest rates fall, this gives an opportunity to bond holders to sell their bond and capitalise on the gain.

This above means that the price of a bond and its yield are inversely related. (the yield on a bond is actually the rate of return on a bond investment).

Bond Pricing Calculation

To help us understand how bonds are priced and how this price affects the amount an investor pays for his bonds let us take 3 scenarios:

To buy 10,000 nominal worth of a bond:

a)      If the price is €100.00, it will cost the investor €10,000 (1.00 X 10,000 nominal)

b)      If the price is €95.00, it will cost the investor €9,500 (0.95 X 10,000 nominal)

c)      If the price is €105.00, it will cost the investor €10,500 (1.05 X 10,000 nominal)

It is important to note that notwithstanding the amount paid for the bond, the investor will still receive the same amount of interest since interest payments are calculated on the nominal purchased and not the amount of cash used to purchase that nominal.

In scenario B for example, the investor is paying €9,500 but will receive interest based on 10,000 nominal.

It goes without saying that the price used to purchase a bond will also affect the yield (return) on that particular bond investment. Bond Investors use Yield to Maturity (YTM) as an indicator of how much they would actually be receiving if they hold a bond to maturity. The YTM is displayed on all bond sheets that are issued by stockbrokers. (also see screenshot above)

Taking the example below, one can see that although the coupon is different, if a holder holds the bond to maturity the return from the investment would be almost the same.

Duration of Bond Coupon Price YTM (Yield to Maturity) 
10 years 7% 95 7.74 %
10 years 8% 102.00 7.71 %

The Advantages of Bonds

Bonds can be sold at any time

The majority of bonds are very liquid instruments and therefore investments in such bonds in not lock up until maturity. (This is a clear advantage over fixed term deposit accounts which do not allow the investor to withdraw the capital before a stipulated time period e.g. 5 years).

Low Risk

Investment Grade Corporate and Sovereign Bonds are generally safe instruments and are less volatile than shares. Unless the bond issuer files for bankruptcy, the nominal amount is always paid back at 100.

A sound alternative to traditional bank deposits

Interest rates on bonds are typically higher than the rates paid by banks on savings accounts. In the long term, bonds give a relative better return than traditional bank deposits albeit at slightly higher levels of risk.

Predictable Regular Income Stream

By investing in bonds, an investor will know a priori how much interest s/he is expected to receive, how often s/he will receive it, and when the principal (the bond’s face value) will be repaid (maturity date). People on a fixed income and/or in retirement will receive an additional predictable amount of regular income from bonds.

Bonds are Good Collateral for Loans

If an investor needs to borrow money, most banks will accept bonds as collateral for loan purposes (as long as the bonds are of investment grade status). Furthermore, the interest income from the bond may be enough to pay the interest charges on the outstanding bank loan.

Capital gains on bonds.

Although making a capital gain is not the primary reason for investing in bonds, throughout the life of the bond, the price of a bond can go up as well as go down, providing investors with opportunities to buy when the market drops and sell when the market is rising. In doing so, investors can realise capital gains on their bond investments.

5 Tips to Managing Bond Portfolio Risk

One of the key benefits of investing in Bonds is the relatively low level of risk associated with this type of investment as opposed to investments in other asset classes. Bonds provide a more stable level of return compared to returns in equity or equity-like investments whilst avoiding the drawbacks of volatility in value. However, each bond does carry an intrinsic level of uncertainty. For this reason it is important to follow a few simple rules to manage this risk effectively.

1. Diversify your investment portfolio

When creating a bond portfolio, it pays to think strategically. Look to diversify by both maturity and issuer. By not investing more than 15% for example into any single bond you are already limiting your risk substantially. You can also select bonds with different maturities and create your own bond ladder.

What is a Bond ladder?

A bond ladder is portfolio of bonds in which each bond has a significantly different maturity date. The main purpose investors purchase several bonds with different maturity dates is to plan when they will receive the capital back and although bonds can sold at any time, bond holders tend to hold bonds until maturity. (Unless they need the capital or they are making a substantial capital gain and sell an existing bond and re-invest the capital in another bond.)

In a bond ladder, the bonds’ maturity dates are evenly spaced across several months or several years so that the bonds are maturing and the proceeds are being reinvested at regular intervals. The more liquidity an investor needs, the closer together his bond maturities should be.

2. Find the right risk/reward ratio

A bond is often valued by its quality which indicates the level of risk associated with the debt.

The higher the quality of a bond, the lower the probability the bond issuer will default on its obligations/payments however the lower interest the issuer has to pay to borrow money from bond holders.

When investing in bonds for income, an investor must balance the necessity to assure his/her capital is returned with the level of income that is on offer. This will provide an investor with a risk/reward ratio that will help find the right investment for him/her.

For example, normally a bond that pays a higher coupon will attract a higher level of risk. It is important for you to be comfortable with the level of risk.

Credit Ratings

A good indicator of the level of risk can be obtained by credit ratings.  Generally when building an investment portfolio for the first time, it is a good idea to start with low risk bonds. It is good that an investor should shift from low risk bonds to the higher risk bonds only once they begin to grasp the concept of the mechanics of the bond market.

Moody’s and S&P are the major rating agencies. Below is a table of how they rate bonds and what they mean.

Moody’s

S&P    

 

Aaa

AAA

Prime

Aa1

AA+

High grade

Aa2

AA

Aa3

AA-

A1

A+

Upper medium grade

A2

A

A3

A-

Baa1

BBB+

Lower medium grade

Baa2

BBB

Baa3

BBB-

Ba1

BB+

Non-investment grade
speculative

Ba2

BB

Ba3

BB-

B1

B+

Highly speculative

B2

B

B3

B-

Caa1

CCC+

Substantial risks

Caa2

CCC

Extremely   speculative

Caa3

CCC-

In default with   little
prospect for recovery

Ca

CC

C

C

D

In default


3. Understand The Company You Are Investing In

When buying any fixed income instrument, it is essential you are comfortable with the organisation with which you are placing your funds.

Though credit ratings will provide you with some guidance as to whether your investment is secure, it is always worth carrying out your own investigation and seeking advice from an independent financial advisor.

Obtaining market research and financial reports can also give you the information you require to ensure that your decision is based on sound business sense.

4. Understand What You Are Buying

The term ‘bonds’ covers a multitude of investment products and, even within the traditional definition of a bond, there are a number of asset classes as well as sectors.

Though all standard bonds will sit above equity investors in the asset class ranking system, the level of claim that you have against a company’s assets will depend on the class (seniority/rank) of bond you have purchased.

Traditionally corporate bonds will sit within the ‘senior debt’ section of a balance sheet. This means that the claim on assets will be stronger than that of subordinated debt but, will sit below that of any secured debt. Subordinated debt and lower ranking bonds form part of a lower section in the balance sheet and therefore have a much lower claim on the asset base.

It essential to be aware of the type of bond you are buying and of the quality of claim you would have on an organization’s assets, should the issuer default on its financial obligations.

Secured / Unsecured

A bond can be secured or unsecured.

Unsecured bonds are guaranteed only by the credit of the issuing company. If the company fails, you may get little of your investment back and therefore one must ensure that the company is financially sound before investing in an unsecured bond.

On the other hand a secured bond is a bond in which specific assets are pledged to bondholders if the company cannot repay the obligation.

Liquidation Preference

In the event that a firm goes bankrupt, it pays money back to investors in a particular order as it liquidates. After a firm has sold off all of its assets, it begins to pay out to investors. Senior debt is paid first, then junior (subordinated) debt, and equity holders are the last in line to get paid.

Perpetual Bonds

A perpetual bond is a bond with no maturity date. Perpetual bonds are not redeemable (unless called) but pay a steady stream of interest forever. Perpetual bonds are more efficient for the government and companies to issue since it avoids the cost of refinancing costs associated with bond issues that have maturity dates. Like other bonds, perpetual bonds can be sold at any time. Currently, one would recognise a perpetual bond in a bond list due to the maturity date being listed as a 2049. (this is not really the maturity date but just a standardised date to help investors spot these bonds.) Investors should seek clarification from their investment advisor on bonds listed with maturity of 2049.

Floating-Rate Note Bonds – (FRNs)

This is a bond with a variable interest rate. The adjustments to the interest rate are usually made every six months and are tied to a certain money-market index. Also known as a “floater.” These bonds protect investors against a rise in interest rates (which have an inverse relationship with bond prices), but also generally carry lower yields than fixed notes of the same maturity. It’s essentially the same concept as an adjustable-rate loan, except FRNs are investments (not debt).

Callable Bonds

Some bonds can be redeemed by an issuer prior to its final maturity date, at a number of pre-determined dates. If a bond has a call provision, it may be redeemed at earlier dates, at the option of the issuer, usually (but not necessarily) at a slight premium to its original par value.

5. Investigate Both the Primary or Secondary Bond Market

When buying bonds for income investment some investors will look to the primary market to purchase new issues of bonds and then hold the paper until maturity. However, this is not the only way to generate an income from a bond investment.

The secondary bond market provides the opportunity for bonds to be freely traded. This offers potential income investor access to a much greater range of investment opportunities and also enables existing bond holders the opportunity to liquidate their asset before their investment reaches full term.

When looking for investment opportunities within bonds, do not limit your search. Investigate the opportunities within both markets and choose the product that most suits your needs. Once again an independent investment advisor will help you to narrow down your search.

Other things to know about bonds

The Difference between Bonds and Shares

Investors usually invest in bonds and shares for the following reasons.

Bonds – Regular Income & lower risk

Shares – Capital Growth and dividends (on shares that pay dividends)

Holders of bonds have no equity holding in the company in which they invest and therefore have no ownership status. A bond holder is considered a creditor of the company in question and therefore has a lender’s rights for capital and interest but not ownership rights.

An investor who buys shares in a company on the other hand buys a small part of that company.

In the case of a bond holder, the investment made is for a fixed duration (if the bond is kept by the investor until maturity) and the date of maturity is always known. Shares on the other hand can be held for as long as the company exists.

Watch a video about Stocks vs Bonds here.

OK I am ready, how do I get started?

Buying Bonds

Bonds can be bought in two ways,

a) In the initial offering period, when they are offered for the first time to the market, better known as the primary market (via a stockbroker and/or lead manager taking part in the issue)

The majority of bonds are issued at PAR (100.00) and are redeemed at PAR

b) On the secondary market (either on an exchange or Over-The-Counter) at any time during the lifetime of the bond.

Bonds are, more often than not, bought in batches of 100’s, 1,000’s, 10,000’s or 100,000’s. The amount of bonds one purchases is referred to as the nominal amount.

Things to Consider

Bond Term.

The level of income generated from a bond compared with the term of the investment is traditionally illustrated on a ‘Yield Curve’. An upward sloping yield curve indicates that the longer the time to maturity, the higher the potential income from a bond will normally be.

If you are looking for a bond to generate the greatest level of income for your investment, consider what the maximum term of investment should be. Take into consideration when you would need your capital returned and your future financial requirements.

However, be careful not to invest all your money for too long. Though long term investments can offer a greater level of income, there is always the possibility that future rises in interest rates could make such an investment much less attractive due to the fluctuations in the value of the bond till maturity.

Interest Frequency

The frequency of an interest (‘coupon’) payment varies between one bond and another, but is generally every 6 months or annually.

An investor will know beforehand the exact coupon payment dates as well as maturity date.

Furthermore, the dirty value of bonds will increase prior to payment dates to take into consideration interest due. So, an investor must be aware of the price that is being quoted prior to investing.

How Much Should You Put into Bonds?

Determining the asset allocation of your portfolio involves many factors, including your investing timeline, risk tolerance, future goals, perception of the market and income. For this reason, if you are new to investing, you should always consult an investment advisor to start off with.

There is an old rule that says investors should formulate their allocation by subtracting their age from 100. The resulting figure indicates the percentage of a person’s assets that should be invested in shares, with the rest spread between bonds and cash. According to this rule, a 20-year-old should have 80% in shares and 20% in bonds and cash, while someone who is 65 should have 35% of his or her assets in shares and 65% in bonds and cash.

The Bottom Line

Bonds can contribute an element of stability to almost any investment portfolio. Selectively, bonds are a safe and conservative investment. They provide a predictable stream of income when the shares market underperforms, and act like a great savings vehicles for a given level of risk