A bond is a debt. It is similar to bank loan but works in reverse. In bank loan, the bank lends you some money. But, in bonds, you give money to the bond issuer. You do it by buying bonds.
When buying bonds, money flows from your pocket to the bond issuer. As compensation, you will get an interest (coupons), and when they are due, the issuer will pay the principal. Not only that, like stocks, you also have the potential to get capital gains from trading them.
Is the bond a good investment?
Bonds are a good alternative in portfolio diversification. Most bonds will pay interest rates (called coupon rates) to you periodically.
However, for some bonds, they do not offer coupons rather sold at a discount. Discounted bonds will provide you with capital gains from rising prices.
Like a stock, bond prices change over time. Price increases allow you to get capital gains when selling them. Conversely, you will suffer losses when the price falls.
Prices are sensitive to market interest rates. Prices will rise or when interest rates fall or when bonds are sold below the par price. Conversely, prices fall when interest rates rise.
An increase in interest rates usually occurs when inflationary pressure rises. The central bank usually raises policy rates to reduce inflation, which leads to higher market interest rates. Hence, inflation is one source of the risk of buying bonds. You need to aware of future inflation trends before buying bonds.
Risk is also reflected in the bond maturity and creditworthiness of the issuer. Longer maturities tend to be riskier. Likewise, a poor credit rating indicates lower creditworthiness and higher default risk. Because of this, bonds with longer maturities and lower rating would offer a higher interest rate to compensate for their higher risk.
Why are bonds safer than equity
Both bonds and stocks, both of which offer you benefits when prices go up. You can sell them and get capital gains. However, in general, both have different risks.
Bonds are considered safer than stocks. They offer periodic income to you through coupon payments. Conversely, a company may not pay dividends regularly.
Dividend payment depends on company policy and performance. Not all companies pay dividends regularly. Some of them prefer to withhold dividends to support future business growth. And, you might get dividends in the future. However, some other companies does not pay at all because of poor financial performance. Therefore, stocks do not offer a regular income stream.
Instead, the bond gives you a stream of income from coupons. Coupon payments do not depend on the company’s financial condition. When you buy a bond, you simply take interest payments while waiting for the bonds to reach maturity and get the principal back. Coupon payments ultimately offset some of the volatility that you might see from owning shares in the secondary market.
Just like stocks, you can buy and sell bonds in the secondary market. After the bonds are issued, the sale and purchase of bonds continue until maturity, and the value will fluctuate like a stock. However, if you hold the bonds to maturity, fluctuations will not affect your interest payments, and your face value will not change.
Advantages and disadvantages of bonds
Bonds may not provide profits as high as shares. However, bonds pay interest regularly, so they can help you generate a stable and predictable income stream. When investing in bonds, you are less likely to lose money than stocks.
In addition to cash, government bonds are the safest and most liquid investments. Short-term bonds can be a good place to invest in emergency funds or the money you will need soon.
However, you also need to pay attention to some of the risks inherent in bonds. The three primary sources of bond risk are inflation, credit, and interest rates.
Higher inflation exposes a higher risk of owning bonds. Also, the longer the bond period, the more likely the payment is not in line with inflation. When the inflation rate is higher than the coupon rate, the purchasing power of money from the coupon falls. With the coupons you get, you get fewer goods than before. An increase in inflation also pushes down bond prices because interest rates will tend to rise.
Interest rates are inversely related to bond prices. Bonds are traded just like stocks, so changes in the economy and interest rates could cause bond prices to rise or fall. When interest rates rise, bond prices fall. The longer the bond period, the higher the price fluctuations that result from any change in interest rates.
Next, interest rate risk is greater when the issuer has high credit risk. Credit risk is the risk that your bond issuer will not be able to make payments on time or at all. Government bonds are considered to have a lower risk than, for example, corporate bonds. And in general, credit risk is reflected in the creditworthiness of the issuer and its rating.
In addition to the issuer rating, bond risk also varies depending on the features of each type.
What are the features and types of a bond?
Some essential features of a bond you need to know. These features distinguish the risk and the return you get. They include:
- Bond issuer
- Maturity date
- Par value
- Coupon rate
- Bond currency
- Credit rating
- Embedded provision
Bond issuers can come from governments, corporations, and supranational organizations. The government consists of sovereign governments or national governments and regional governments such as provincial and city governments. Corporate bonds come from financial and non-financial companies. Meanwhile, supranational bonds come from organizations such as the International Monetary Fund and the World Bank.
They issue bonds for some financing reasons such as expanding production facilities, building infrastructure, and financing budget deficits. Bond issuance is preferable since it is cheaper than a bank loan.
From the level of default risk, a sovereign is considered to have a lower risk than municipal and corporate bonds. Therefore, the yield of sovereign bonds is lower and is a reference in pricing the two bonds.
Maturity date of a bond
The maturity date refers to the date on which the issuer will repay all the principal of the bond. The period between the issue date and maturity is what we call the tenor.
Bonds vary according to tenor; some are three years, five years, ten years to twenty years. The longer the bond tenor, the riskier the bond, so that it will offer a higher yield rate. The relationship between maturity and yield is called the yield curve.
In general, yields are inversely related to bond prices. When prices rise, yields will fall, and the reverse relationship applies. Price increases allow you to gain capital gains when selling your bonds.
Furthermore, bond prices are sensitive to market interest rates. An increase in market interest rates causes bond prices to fall (yields to rise). Conversely, a fall in market interest rates pushes prices up (yields to drop)
Par value refers to the principal amount that the issuer will pay on the due date. Sometimes, this term is also known as face value and nominal value. In bond trading, bond prices are quoted as a percentage of their face value. For example, a quotation of 95 from the face value of Rp1,000 bonds indicates that the current bond price is Rp950 (=95% × Rp1,000).
Quotations make it easier for us whether a bond is traded at a premium, discount, or par. When the price is above 100%, the bond is at a premium. Whereas, the quote at 100% of the nominal shows that the bond is traded at par. Lastly, when below 100%, then the bond is at a discount.
At maturity, the price of a bond is always at par. So, when trading at a premium, bond prices tend to fall near the maturity date. Conversely, discount bonds will see price increases near the maturity date.
Coupons refer to the amount of annual interest that the issuer will pay to bondholders. We call the coupon proportion per the nominal value of the bond as the coupon rate, which is similar to bank loan interest. For example, a bond with a coupon rate of 6% of the face value of Rp1,000 bonds means the issuer will pay an annual interest of Rp60 (6% × Rp1,000).
The issuer will pay coupons periodically until they are mature. Coupon payments can be annually, semiannually, quarterly, or monthly. So when the bond payments in the example are quarterly, the bondholders will receive a coupon of Rp15 (Rp60 / 4) every three months.
In fixed-rate bonds, issuers pay a fixed coupon rate from the first issue to maturity. For example, if the issuer offers the coupon rate at 6% and pays it semiannually, bondholders will receive a coupon payment of 3% of the face value every six months. The percentage is unchanged, regardless of interest rate and inflation trends in the economy.
In contrast, floating-rate bonds offer variable coupon rates—the percentage changes from time to time. For example, the coupon rate formula is 2% + reference interest rate. The most widely used reference interest rate is the London Interbank Offered Rate (LIBOR).
Variations of bonds with floating coupon rates are bonds adjusted for inflation. An example is Treasury Inflation-Protected Security (TIPS). TIPS protect investors from rising prices because the nominal value will increase when inflation increases.
The next type is zero-coupon bonds. Issuers do not pay a coupon at all. Instead, in attracting investors, they release at discount prices. Because it is sold at a discount, bond prices will slowly rise to near par, and investors will get capital gains when selling it.
Bonds also vary according to the currency of the bond. Generally, issuers issue domestic currency bonds (local currency bonds) when the target is local investors. These bonds have no translation risk because both investors and bond issuers use local currencies in their operations. However, such bonds are relatively less attractive to global investors.
To attract global investors, issuers can release it in international currency denominations such as the US dollar and the Euro. We call it global bonds. The issuance is to make it more attractive to investors, especially if the local currency is relatively unstable or liquid. However, bond issuers assume translation risk when their exchange rates fluctuate against the US dollar or the Euro.
Translational effects can be positive or adverse effects. For example, when the domestic currency exchange rate depreciates against the US dollar, the issuer must collect local currency more to redeem bonds. Conversely, when the appreciation of the domestic currency makes redemption cheaper.
Bonds also vary according to the creditworthiness of the issuer. Creditworthiness shows the issuer’s ability and willingness to pay for coupons and redeem the principal when due. When they are unable to fulfill their obligations, the issuer defaults.
The default rate is positively related to the coupon rate. The higher the issuer fails to pay, the higher the coupon rate it will pay. Investors consider it riskier, hence they will ask for higher interest. For the issuer, higher interest rates make funding more expensive.
You can see the issuer’s creditworthiness from a rating assigned by a credit rating agency.
The three largest global credit rating agencies are Standard and Poor’s (S&P), Moody’s, and Fitch. And, they assign ratings from excellent to poor as: AAA, AA +, AA, AA-, A +, A, A, BBB +, BBB, BBB-, BB +, BB, BB-, B +, B, B- , CCC +, CCC, CCC-, CC +, CC, CC-, C +, C, C- and D. Please note, Moody’s and other credit rating agencies might use different letter designations than those.
The highest rating of AAA (or Aaa by Moody’s) indicates the issuer has the lowest default risk, relative to other ratings.
Then, based on its rating, bonds fall into two categories:
- Investment grade is rated BBB- or higher by Fitch Ratings or S&P, or Baa3 or higher by Moody’s. These bonds have relatively low default risk. Therefore, it has a relatively low yield.
- The noninvestment grade is rated below BBB- or Baa3. They have high returns because the risk of default is higher than investment-grade bonds. Other terms for these bonds are high yield bonds, speculative bonds, or junk bonds.
Some bonds also include embedded provisions. This feature gives the right to take specific actions such as put, call, or conversion.
Putable bonds give the right to bondholders to sell their bonds to the issuer before the maturity date at a specified price. Bondholders will usually take advantage of this feature when market interest rates rise. An increase in interest rates makes the price of bonds fall so that by selling it, they can buy other bonds that are more attractive.
The opposite of putable bonds is callable bonds. A callable bond gives the issuer the right to repurchase the bond from the bondholder before the maturity date at the specified price. Issuers usually call bonds when market interest rates fall. By doing so, they can reissue other bonds with cheaper interest.
The next embedded provision is conversion. Convertible bonds are hybrid security, which offers bondholders the right to convert bonds to some common shares at some point before the bond’s maturity date. After conversion, bondholders are no longer entitled to coupons. Instead, they are entitled to the distribution of company dividends.
Some bonds offer collateral to bondholders. We call it secured bonds. The collateral can be in the form of tangible assets, such as property, factories, or equipment.
When a default occurs, the bondholder is legally entitled to own the assets pledged. They can sell these assets to reduce the risk of losing money due to default.
And, when bonds are unsecured, bondholders will usually ask for a higher coupon rate to compensate for higher risk.
More specifically, some unsecured bonds have a lower priority in the event of default than other unsecured bonds. Unsecured bonds with lower priority are referred to as subordinate bonds, which receive payment only after claims with higher priority are fully paid. Furthermore, subordinated bonds can also be ranked according to priority, from senior to junior.