Bonds 101

 

Bonds are typically a word most investors have heard of, but it is an investment that is not fully understood. Shares however, are generally well understood, investors know they can fluctuate in value, they sometimes pay a dividend, they can be risky. Bonds are seen as ‘safer’ investment options, but that is not always the case.

Bonds versus Term Deposits

Comparing a bond to a term deposit from a major bank; a term deposit is an agreement from the investor to lend a specified amount of money to the bank, with an agreed interest rate, with agreed repayment terms. Throughout the term of the investment, the investor will receive interest on monthly, quarterly or at maturity of the investment.

If the investor wishes to receive their money back, prior to the maturity of the investment, the bank will penalise the investor (for breaking their contract) by reducing the amount of interest which is to be paid. In New Zealand, this can turn a 4.5% interest rate (per annum), to a 1.5% interest rate by penalising the lender 3% of the gross interest. This issue is compounded if the bank has already paid out monthly interest to the investor, as it will require a ‘claw back’ of interest before the capital amount (or term deposit) is repaid.

The Key Points of Term Deposits

– Agreed lump sum value

– Set interest rate and payment dates

– Set maturity date

How does this compare with bonds? Bonds operate on similar terms, you know how much you are investing (the capital amount), you know the interest rate (also known as a ‘coupon rate’), you know the payment dates and you know when the bond matures. A bank will use your term deposit money to on lend to borrowers (for the most part), however, if you buy a bond in a telecommunications company, they may use those funds to repay (or refinance) existing debt, they may use it invest in their infrastructure, or they may use it fund day to day operations.

How Bonds are Different

Bond prices fluctuate in value, unlike a term deposit, as you cannot ‘sell’ your term deposit on the open market, there is no ‘secondary market‘ value. A bond however, is able to be sold on the secondary market, just like a share. The value of your bond, depends on the company it is invested in, the coupon payment, the maturity date and the terms and conditions of that specific bond.

Example 1

Let’s say the going interest rates are 5%, Company (or government) “ABC”  with a good credit rating (i.e. their long term prospects look good) issues a bond offer for 10 years. The bond will pay a 5% coupon payment every 6 months for 10 years and repay the bond at the maturity. If you invested $10,000 you would expect to receive $500 per annum for 10 years plus the original $10,000 back at maturity. However, lets assume that 4 years into the 10 year investment you decide you want to go on an overseas holiday, so you want to sell your bond, how much is it worth? It depends what the market will pay for it. Interest rates have a strong influence in the pricing of bonds. If interest rates have gone up since you purchased the investment, a new investor who has approximately $10,000 to invest might be able to get a new, long term bond investment paying 7% per annum. Therefore, your 5% per annum doesn’t look very attractive. In order to entice that investor to buy your bond, you may need to reduce the value you are prepared to sell the bond for. Therefore, you may need to sell your $10,000 bond to the new investor for $9,000. This means, that while the investor will receive only $500 per annum (versus the $700 they could have otherwise received), at maturity they will receive $10,000 back from the maturity of your bond versus the $9,000 they originally paid. This is why the ‘yield‘ of a bond is so important, unlike the interest rate (or coupon) of a secondary market bond the yield takes into consideration the amount paid by the investor plus income received and the amount they will receive at maturity.

Example 2:

Conversely, if interest rates have gone down, to say 3%, a new investor will find your 5% income attractive and may pay you say $11,000, to receive an income stream of $500 per year, rather than $300. However, at maturity, they will only receive the original value of the bond back – $10,000.

Why is Yield Important?

In these scenarios, assuming the underlying government or corporation where the funds are invested are strong, the ‘total return’ for the buyer of the secondary market bond will be in line with other similar bonds. If interest rates are 7%, by the time an investor buys a bond with a discount to its face value (the original amount of bonds purchased – $10,000 in this case) plus the income they receive throughout the bond’s term plus the capital gain they make at maturity, their return will most likely not be far away from the original 7%. That is because the bond holder wishing to sell, needs to make a capital loss. This is also true in the second example, where the bond holder was able to sell their bond at a ‘premium’. While the new buyer of the bond is getting a slightly higher return per annum ($500 vs $300), they are also paying more than $10,000 (face value) for the bond. So at maturity, the new buyer of the bond makes a capital loss, therefore, their yield is likely to be closer to 3% (the current market interest rates) versus the bond’s interest rate of 5%. In this instance, the seller of the bond has made a capital gain. However, the seller of the bond may have made some money on that bond, but if they were to go directly back into the market, they won’t be able to reinvest it at the rate they were receiving on their previous bond.

Interest rates aren’t the only aspects which impact the value of the bond. The outlook of the corporation or government also determine a bond’s value. If the outlook is negative, investors may be willing to sell now, at a lower value than the price they paid by ‘cutting their losses’ and running. An investor who has a contrarian view may see this as an opportunity to buy a cheap investment in the hope of getting their purchase prices back – plus some, when the bond matures.

Security Ranking

Bonds are also ranked – subordinated (down) – unsubordinated (not down)… this determines your position in the queue if a bond issuer were to strike financial difficulties. Sitting at the top of this list are typically the IRD (or governement), its employers (unpaid leave, wages outstanding) then secured creditors then unsecured creditors (not backed by a specific asset). The higher the risk, the lower down the food chain the investor is – and – the higher the reward should be (typically in terms of a higher interest rate).

Other Types of Bonds

Some bonds are perpetual, i.e. they never mature, some bonds are repaid by being converted into company stocks (convertible bond). The point of this article is to show that bonds can be simple, but they are equally very much able to be complex and confusing. Understanding the mechanics of a bond will help investors understand the risk they are taking when making informed decisions.