What is a bond?
Bonds are a popular source of funding for companies and a preferred financial instrument for investors. But what is a bond? How can I buy a bond? And is it a worthwhile investment? Here are the key facts about bonds for beginners.
Bond: Term and interest rates
A bond is an obligation. The issuer of the bond receives money from an investor at mutually agreed terms and conditions and agrees to repay the capital upon maturity. The investor then receives interest as compensation.
So by definition, bonds are fixed-interest securities with a pre-defined term and interest rate. In order for this fixed-interest instrument to adapt to fluctuating market conditions, the price changes in the opposite direction of the interest rate. In other words, higher interest rates result in lower prices and vice versa. Example:
Let's say an investor from Switzerland holds a bond with a face value of CHF 10,000, with a fixed coupon interest rate of 3 percent and a term of ten years. Until the bond matures, she will receive CHF 300 in interest annually.
Meanwhile, market interest rates rise and the same bond now has a 4 percent coupon, i.e. CHF 400 in interest annually. The investor's bond is now relatively unattractive because the coupon interest of her bond is lower than the market interest rate. Thus, the price of her bond drops. This is how both bonds balance out in terms of pricing.
The longer the bond's term to maturity, the more the price will fluctuate. The further away a bond is from the redemption date, the more sensitive it will be to changes in the interest rate environment. This sensitivity is known as the duration of a bond.
Bond: The bond issuer
Bond issuers can be governments or companies. With (western) governments, investors are assured of redemption. The creditworthiness of a company is determined by the quality of its balance sheet and its earning power. This creditworthiness is analyzed by independent agencies and expressed as a rating. The amount of bond interest is tied to this rating.
If the issuer has a healthy balance sheet and good earnings power, the investor can be assured that the bond will be repaid. They will receive a relatively low interest payment. If the balance sheet is questionable or earnings unstable, then investors will need higher interest rates to make their investment relatively attractive.
If the underlying conditions change, then the rating often will as well, which affects the interest on the bonds. For instance, a company can improve its rating by reducing its debt levels. Conversely, the rating will be downgraded if an issuer is at risk of insolvency. This is known as the issuer's creditworthiness.
Bond: Risks and returns
Although bonds are very stable, predictable investments, they cover a wide range of risk/return profiles. For instance, a portfolio of sovereign bonds with a good credit rating and low duration will have little price fluctuation but also a low interest rate.
To earn higher interest, investors must take additional risks. In this case, they may make concessions on the term to maturity, which increases the interest rate risk. Or they may make concessions on the creditworthiness of the issuer, which in turn means greater sensitivity to economic conditions. This can influence the probability of redemption.
All bond portfolios eliminate the specific risks by diversification, i.e. making a large number of different investments. For instance, higher interest rates on the short end can be made up for by lower interest rates on the long end. A downgrade or default of an issuer is also less critical if the portfolio has dozens or hundreds of other bond investments.
Bonds are generally traded on the stock exchange and kept in a safekeeping account. Note that in trading, the liquidity of a bond can sometimes be very low, which means major differences between the purchase and sale price.