Guide to Essential Money Tools

Investing Tools

The case for bonds

Bone up on bonds with this essential fact-file.

A bond is just a loan but in the form of a security, explains Ashburton. The key to understanding the bond market is that when you buy a bond, you are lending someone money, be it a government or an organisation. 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.

Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds.

Since bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and increase their capital or to receive dependable interest income.

Bond types
The majority of bond issuance comes either through governments or corporate companies wishing to raise money. Government bonds issued by the majority of G7 countries are deemed the safest of all bonds as the interest and principal payments are guaranteed by the full faith and credit of the government.

The value of corporate bonds depends on the credit worthiness of the company offering them. Corporate bonds carry higher risks and therefore higher yields than the top quality governments. Good quality corporate bonds are known as ‘investment-grade’ bonds. Corporate bonds with lower credit quality are called ‘high-yield’, or ‘junk’, bonds. Junk bonds typically pay higher yields than other corporate bonds to compensate for the additional risk.

Fixed income securities promise to pay the holder a fixed single payment at some point in the future, and/or a stream of fixed payments at pre-specified dates.
Floating rate notes pay an interest rate that tracks the prevailing market rate. The interest rate on a floating rate bond is reset periodically in line with changes in a base interest rate.

Inflation-indexed linked bonds pay a real rate of interest on a principal amount that rises or falls with the retail price index. You don't collect the inflation adjustment to your principal until the bond matures or you sell it.

Zero Coupon bonds pay no coupon but only a redemption value and are therefore offered at a deep discount. The advantage of these types of bonds to the investor is that they embody no reinvestment rate risk.

Returns
Yield is the return you actually earn on the bond, based on the price you paid and the interest payment you receive. There are basically two types of bond yields an investor should be aware of, current yield and yield to maturity.
Current yield is the annual return on the amount paid for the bond and is derived by dividing the bond’s interest payment by its issue price.

Yield to maturity, which is considered more meaningful, tells you the total return you will receive by holding the bond until it matures. 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.

Risk versus reward
As a general rule, bond markets rise (when interest rates fall) and bonds are generally viewed as safer investments than stocks. Bonds have less day-to-day volatility than stocks, and bonds' interest payments are higher than dividend payments that the same company would generally choose to pay to its stockholders. Bonds are also liquid, it is fairly easy to sell one’s bond investments, moreover, many like the certainty of a fixed interest payment once or twice per year.

However, bonds still have various risks attached. Fixed rate bonds are subject to interest rate risk, meaning their market price will decrease in value when the generally prevailing interest rate rises. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When interest rates rise, then the market price for bonds will fall, reflecting investors’ improved ability to get a good interest rate for their money elsewhere, perhaps by purchasing a newly issued bond that already features the newly higher interest rate.

Conversely, when interests fall, the market price of the bond will rise and this has been the case over the last 25 years as bonds have been in a long-term bull market.

Conclusion
It is important to remember that bond prices can become volatile if one of the credit rating agencies like Standard & Poor’s or Moody’s upgrades or downgrades the credit rating of the issuer. The less creditworthy the organisations you are lending to, the more reward you should expect for doing it. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond’s interest payments, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.