What are bonds and how do they work?

Summary

• Bonds are a fixed-income instrument that represents a loan made by an investor to a borrower. In simple words companies and countries borrow money from investors and generally pay it back at a fixed date. During the lifetime of the bond the company or country pays interest to the investors.
• Governments and companies (large or small) opt to issue a bond in order to raise capital to fund their growing business and operations, fund new projects or re-finance already outstanding debt, amongst other things.
• Bonds feature maturity dates at which point the principal amount must be paid back in full. Bond prices are directly connected to interest rates, so when rates go up, bond prices fall and vice versa, however these are normally less volatile than shares.
• The face value, the interest rate or yield, the maturity date and issue date are all characteristics of bonds.
• The stronger the issuer (e.g. Government) the lower the risk so the interest rate is also usually lower, whereas the more indebted the company, the higher the risk and therefore, a higher interest rate is paid.
• From preserving capital to offering a predictable return, there are several benefits to investing in bonds, while the fact that there is a wide choice means that there is a bond to match investors’ different needs.
• Before selecting a bond, one should check the bondholder’s ratings and bear in mind the potential risks such as credit risk and liquidity risk to name a few.
• Need help to invest in bonds? Get in touch with Calamatta Cuschieri and our team of expert investment advisors who have been investing in bonds for almost 50 years.

Baffled by the wide variety of investment options out there? Whether you’re looking for another source of income or to fund your retirement, bonds can contribute to your portfolio and can offer an element of stability and diversification. In addition, they can provide a predictable stream of income when stocks perform poorly.

But with investment jargon like bonds, yields, coupons and more, the bond market can be confusing to many. Here, we outline everything there is to know about bonds and why you should consider including them in your investment portfolio.

What are bonds?

A fixed-income instrument that represents a loan made by an investor to a borrower, bonds are used by companies or the government in order to raise capital. These entities will in turn use the funds to finance projects, grow their business, maintain ongoing operations, buy property and equipment, refinance existing debt or it may be used for research and development purposes.

Many organisations typically need far more money than what the average bank can provide. When companies need outside financing to continue growing, they can opt for a diversity of channels to raise the necessary capital. For instance, one option could be the selling of existing equity stake to the public, better known as an Initial Public Offering (IPO). In such a case, the company would be raising capital by floating shares in the primary market to outside investors, becoming a public company In this case, the new investors will hold an ownership in the company. Another option is the issuance of bonds, whereby the company borrows money from investors who are willing to lend money to the company.

When the bond matures the issuer pays the holder back the original amount borrowed, known as the principal, however, throughout the tenor of the bond, the issuer must also pay a regular pre-agreed fixed interest payment for a pre-agreed period of time.

The market value of the bond changes over time as it becomes more or less attractive to potential buyers. At the same time, bonds that are considered of a higher-quality usually pay a lower coupon (or interest rate) for the lower risk being taken, whereas the opposite is true for bonds that pose higher operational and financial risks. In addition, a higher return is expected for bonds with longer maturities and comparable levels of risks, something that is better known as maturity premium.

How do bonds work?

Bonds are created in the primary market and it is in this market where companies sell new bonds to the public for the first time, like with an IPO. On the other hand, the secondary market is where those securities are traded by investors. Understanding how the primary and secondary markets work is key to understanding how bonds trade.

Bonds have a face value, but they also have a market value which fluctuates. There is also a close correlation between yield and price. A bond’s yield is the result of dividing the bond’s coupon by its changes in value, also known as the current yield – in other words, the return an investor would generate if the bond is held for one year. Bond yields move inversely with bond values, which means that the more demand there is for bonds, the lower the yield. The reason for this being so is due to the secondary market activity. As the demand for bonds increases, investors pay a higher price to purchase them, however, the interest rate to the bondholder remains fixed and giventhe price investors paid for the bond in the secondary market is higher, this yields a lower return.

Generally speaking, the initial price of most bonds is typical set at par, usually at €100 or €1000 per individual bond. When it comes to the market price of a bond, this will depend on factors like the issuer’s credit quality, the length of time until maturity, the coupon rate and others.

For a better understanding, let’s look at a practical example. In April this year, Netflix, the American media services provider issued a bond with the following characteristics;

• Issuer: Netflix
• Coupon: 3.625%
• Currency: USD
• Maturity: 15/06/2025
• Rating: BB (S&P)
• Ranking: Senior Unsecured
• Issue Price: 100
• Coupon Frequency: semi-annual

Looking at the above bond characteristics, Netflix issued a bond at 100, also known as par, through the primary market in U.S. dollars and it will be paying a fixed coupon of 3.625% paid every six months. The tenor of the bond is of five years and therefore in 2025, the company will pay back the last coupon in addition to the principal originally borrowed. From the above details, you may also notice that this bond issue is rated BB by Standard & Poor’s, while its ranking is senior unsecured which implies that secured loans, usually bank loans, are ranked higher that this bond issue.

Bonus: Some common characteristics of bonds

• Face value: this refers to the amount of money the bond will be worth at maturity. This amount is used by the bond issuer when calculating interest payments.
• Coupon rate: this is the rate of interest the bond issuer will pay on the face value of the bond which is typically showcased as a percentage.
• Coupon dates: these are the dates that indicate when the bond issuer will make the interest payments. Typically, these are done twice a year.
• Maturity date: the date when the bond will mature and the issuer will have to pay the face value of the bond.
• Issue price: the price at which the bond issuer sells the bond originally.

Understanding secured vs. unsecured bonds

Available as either secured or unsecured, each option offers different opportunities and challenges to an investor. Secured bonds are typically backed by an asset, be it another income stream or property for instance, so if the issuer defaults and fails to make interest or principal payments, investors have a claim on the issuer’s assets. At times, the asset sale may not result in enough money to pay back investors fully.

In contrast, unsecured bonds are not secured by a specific asset and as such an investor has no claim on a particular collateral. On the other hand, in cases when a company has both unsecured and secured bonds outstanding and is struggling to service its financial obligations, it might opt for a liquidation or the more common practice of restructuring its capital structure. This means that in the former case, existing bondholders, accept a haircut on the nominal amounts under newly issued bonds which will hold different terms from the original investment. This move should ease the company’s financial pressures given the lower debt levels. When being faced with the latter, secured bondholders will usually accept a lower haircut in capital, when compared to senior unsecured bondholders which usually bare a much higher burden.

Why should you invest in bonds?

Bonds form an important part of any diversified portfolio and feature several advantages. These include:

• They serve as a means for preserving capital, while they offer the possibility to earn a predictable return.
• If you hold the bond to maturity, you could possibly be getting all your principal back.
• Interest rates on bonds are often higher than savings rates at banks, while they tend to perform well when stocks are declining.
• With a wide variety of bonds including fixed rated bonds, floating rated bonds and convertible bonds to name a few, there is a bond for every investor.
• They may be low-risk depending on the company’s operational and financial leverage, which means that at times they are considered a safer investment option, while these tend to suffer less from day-to-day market volatility.
• They can be packaged as bond mutual funds which reduces risks further through diversification, while an experienced fund manager will pick the best selection of bonds for you and manage your portfolio on your behalf.

What are the disadvantages of investing in bonds?

As is the case with any type of investment, bonds too have drawbacks.

• Bond yields can fall and could pay out lower returns over the long haul than other forms of investments like stocks.
• Bond prices rise when rates fall and in contrast, they fall when rates rise. This means that your portfolio could suffer market price losses in a rising interest rate environment, so interest rate volatility could affect the prices of individual bonds irrespective of the issuer’s underlying fundamentals.
• Companies can default and this is why you should always check the bondholder’s ratings which offers a clear indication of the levels of risk. Any bond issue with a BB or lower rating, implies higher levels of risk and should be avoided.
• Although bonds are considered relatively safe, there could be a number of risks involved such as credit risk, whereby the issuer defaults and fails to pay your promised principal or interest.

Types of bonds

Depending on who issues them and according to factors such as the length of maturity, interest rate and risk involved, there are several different types of bonds to choose from. Here are the primary categories sold in the market.

Corporate bonds: these are bonds issued by companies. Businesses often issue bonds as opposed to seeking bank loans since they offer more favourable terms and possibly lower interest rates given the current yielding scenario. The risk and return of these bonds greatly depend on how credit-worthy the company is.

Government bonds: often referred to as treasury bonds and sovereign debt, bonds issued by national governments may be the safest option, however, they pay the least interest. Long-term treasuries that reach the 10-year benchmark may offer slightly less risk and marginally higher yields.

Agency bonds: these are bonds that are issued by government-affiliated organisations. They are typically known for being low risk and for having high liquidity.

In addition, bonds may also be categorised according to other factors like the rate or type of interest, the coupon payment and other attributes.

Credit ratings also play an important role. The rating a company or bond receives is generated by credit rating agencies like Standard & Poor’s and Moody’s. High-quality bonds are known as investment grade and include debt issued by governments and less indebted companies, whereas those not considered investment grade are better known as sub-investment grade or speculative grade bonds.

Raising capital with CC’s Capital Markets team

Whether executing an IPO, a debt offering or a leveraged buyout, CC’s Capital Markets team responds with market judgement and ingenuity to clients’ need for capital. Combining our expertise in sales, trading and investment banking, we offer clients seamless advice and solutions that help business grow through the capital markets.

Once you get used to them, bonds are a fairly simple product to understand, however, selection can be very complex. Bonds are hugely popular with knowledgeable investors and are worth considering if you want to build a diversified portfolio since they can be a good means for building an investment portfolio that provides regular income.

One of Malta’s largest independent financial services group and a founding member of the Malta Stock Exchange, Calamatta Cuschieri pioneered the local financial services industry in 1972. Since then, CC has established itself as a 360-degree financial planner for investments, pensions and life insurance. CC can help you create a diversified bond portfolio thanks to our large array of investment options available. Visit one of our local branches for a FREE financial health check which includes a review of your current financial situation and a customised financial plan tailored to your needs.