What are bonds?
A bond is a debt security. When you purchase a bond, you are lending money to a government or a private corporation or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it “matures”, or comes due.
There are various types of bonds you can choose from: local and foreign government securities, corporate bonds, developing country bonds and eurobonds.
Why invest in bonds?
Most investment firms recommend that investors maintain a diversified investment portfolio consisting of a range of securities in varying percentages, depending upon individual circumstances and objectives. Because bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and to increase their capital or to receive dependable interest income.
What aspects do I have to look for if I choose to invest in bonds?
There are a number of key variables to look for when investing in bonds: the bond’s maturity/redemption date, redemption features, credit quality, interest rate, price, yield to maturity and tax status. Together, these factors help determine the value of your bond investment and the degree to which it matches your investment objectives.
Maturity
A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Bond maturities generally range from one day up to thirty years. Maturity ranges are often categorized as follows:
- Short-term notes: maturities of up to 4 years;
- Medium-term notes/bonds: maturities of 5 to 12 years;
- Long-term bonds: maturities of 12 or more years.
Redemption Features
While the maturity period is a good guide as to how long the bond will be outstanding, certain bonds have structures that can substantially change the expected life of the investment. For example, some bonds have redemption or call provisions that allow or require the issuer to repay the investors principal at a specified date before maturity. Bonds are commonly called when prevailing interest rates have dropped significantly since the time the bonds were issued. Before you buy a bond, always ask if there is a call provision and, if there is, be sure to obtain the yield to call in addition to the yield to maturity. Bonds with a redemption provision usually have a higher return to compensate for the risk that the bonds might be called before maturity.
Your choice of maturity will depend on when you want or need the principal repaid and the kind of investment return you are seeking within your risk profile. Some individuals might choose short-term bonds for their comparative stability and safety, although their investment returns will typically be lower than would be the case with long-term securities. Alternatively, investors seeking greater overall returns might be more interested in long-term securities despite the fact that their value is more vulnerable to interest rate fluctuations and other market risks. Longer term bonds will fluctuate more than short term bonds even though they might have higher yields to maturity.
Credit Quality
Bond choices range from the highest credit quality, which are backed by the full faith and credit of the issuing entity (such as the government), to bonds that are below investment grade and considered speculative.
When a bond is issued, the issuer is responsible for providing details as to its financial soundness and creditworthiness. This information is contained in a document known as an offering document or prospectus. If your intermediary is not able to provide you with a copy of this document, you should request a summary of the main features attached to the bond which you intend to purchase. Such features would normally include: information about the issuer, name of the bond (including coupon, date of maturity), current price, accrued interest (if any), frequency of coupon payments, redemption information, ratings.
Make sure that all information given to you verbally is put down in writing for future reference.
Sovereign Risk
Some investors, including Maltese, are tempted by the prospect of earning high yields by investing in emerging country bonds. However, although the annual or semi-annual coupon payment can be quite high, most investors tend to discount the underlying country or sovereign risk. It is risk inherent in holding shares, bonds or other securities whose fortunes are closely allied with a particular country. If the country goes into an economic downturn, or its debt is downgraded (see next question), or the international investor sentiment just turns against it, your investments may well lose value. Generally speaking, sovereign risk is more of a problem for investors in emerging markets than in developed economies.
Of course the very volatility of emerging markets also presents opportunities, although retail investors should exercise extra caution when investing in such securities.
But how can I know whether the company of goverment entity whose bond I am buying will be able to make its regularly scheduled interest payments in 5,10,20 or 30 years time?
You may have heard your intermediary mention the term “triple A” or simply an “A”. These are called ratings. Each international bond is usually given a rating by a rating agency. These agencies, such as Standard and Poor’s or Moody’s, give these ratings when they are issued and monitor developments during the bond’s lifetime. Such agencies maintain research staff that monitor the ability and willingness of the various companies, governments and other issuers to pay their interest and principal payments when due. Your investment firm can supply you with current research on the issuer and on the characteristics of the specific bond you are considering.
Each of the agencies assigns its ratings based on an in-depth analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (Standard & Poor’s) and Aaa (Moody’s). Bonds rated in the BBB category or higher are considered investment-grade; securities with ratings in the BB category and below are considered below investment-grade.
It is extremely important to understand that, for any single bond, the high interest rate that generally accompanies a lower rating is a signal or warning of higher risk.
Credit Ratings
| Credit Risk | Moody’s | Standard & Poor’s |
| Investment Grade | ||
| Highest Quality | Aaa | AAA |
| Highest Quality (Very Strong) | Aa | AA |
| Upper Medium Grade (Strong) | A | A |
| Medium Grade | Baa | BBB |
| Non Investment Grade | ||
| Somewhat Speculative | Ba | BB |
| Speculative | B | B |
| Highly Speculative | Caa | CCC |
| Most Speculative | Ca | CC |
| Imminent Default | C | D |
| Default | C | D |
Interest Rate
Bonds pay interest that can be fixed, floating or payable at maturity. Most bonds carry an interest rate that stays fixed until maturity and is a percentage of the prinicpal amount. Typically, investors receive interest payments semi-annually. For example, a EUR1,000 bond with an 8% interest rate will pay investors EUR80 a year, in payments of EUR40 every six months. When the bond matures, investors receive the full face value of the bond, that is EUR1,000.
But some sellers and buyers of bonds prefer having an interest rate that is adjustable, and more closely tracks prevailing market rates. The interest rate on a floating-rate bond is reset periodically in line with changes in a base interest-rate index.
Some bonds have no periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the face value of the bond plus the total accrued interest, compounded semi-annually at the original interest rate. Known as zero-coupon bonds, they are sold at a substantial discount from their face amount. For example, a bond with a face amount of EUR20,000 maturing in 20 years might be purchased for about EUR5,050. At the end of the 20 years, the investor will receive EUR20,000. The difference between EUR20,000 and EUR5,050 represents the interest, based on an interest rate of 7%, which compounds automatically until the bond matures.
Price
The price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to their face value. Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
Yield
Yield is the return you actually earn on the bond, based on the price you paid and the interest payment you receive.
The yield to maturity tells you the total return you will receive by holding the bond until it matures or is called. It also enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity (including interest on interest at the original purchasing yield), plus any gain (if you purchased the bond below its par, or face value) or loss (if you purchased it above its par value).
You should ask your intermediary for the yield to maturity on any bond you are considering purchasing. Your intermediary will also help you understand better how the yield to maturity is calculated.
Market Fluctuations: The Link Between Price and Yield
From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds, and true of the entire bond market, with every change in the level of interest rates typically having an immediate effect on the prices of bonds.
When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues. When prevailing interest rates fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues. Because of these fluctuations, you should be aware that the value of a bond will likely be higher or lower than both its original face value and the purchase price if you sell it before it matures.
Assessing Risk
Virtually all investments have some degree of risk. When investing in bonds, it is important to remember that an investment’s return is linked to its risk. The higher the return, the higher the risk. Conversely, relatively safe investments offer relatively lower returns.
Secured vs Unsecured
Secured bonds are those bonds which are backed by a specific asset or revenue stream. If the company which issued the bonds becomes financially insolvent, the secured bondholders have first access to that asset, or to revenue provided by the specific asset. If this occurs, investors are able to collect at least a portion of what they are owed
When bonds are unsecured, this means that repayment of capital is not collateralised by a security on specific assets of the issuer in the case of a bankruptcy or liquidation or failure to meet the terms for repayment. These bonds are not backed by anything but your trust and the company’s commitment to pay.
Subordinated vs Unsuboridinated
