Bonds

Bonds are income investments in which investors lend money to the bond issuer (government or corporation) and the bond issuer undertakes the obligation to pay a fixed interest rate for a certain period of time until the bond matures. In fact, just like consumers borrow money to meet their financial obligations, so do governments and corporations. Yet, instead of borrowing the money from a financial institution, they borrow it from a number of investors in the form of a bond.

  • Features of bonds
    • Regardless of the issuer, bonds have certain fixed characteristics. These are:
  • Par Value (face value)
    • This is the nominal amount that the bondholder is obliged to repay to the issuer at maturity. The borrower pays interest on the face value. Typically, the par value of a UK bond is 100£, while for a US bond is $1,000.
  • Maturity date
    • This is the date on which the face value of the bond should be repaid. Provided that all due payments have been made and that the borrower has no further obligations to the issuer, the bond expires on maturity date. Most bonds have a maturity between 10 to 30 years.
  • Interest rate (coupon)
    • The coupon is the interest rate that the issuer is obliged to pay to the borrower. It is known as "coupon" because, in the past, bonds had coupons attached and the bondholders would exchange the coupon in the bank for the interest payment. Normally, the coupon is a fixed rate during the life of the bond and it is the product of the division of the coupon payment by the face value. So, if the face value is 1,000£ and the coupon payment is 80£, the coupon will be 80£/1000£ = 8%.

      Variable interest rates are related to the Libor (London Interbank Offered Rate). Should London leading banks borrow from foreign financial institutions, the Libor would be the average interest rate. Bonds with variable interest rates are known as floating-rate bonds.
  • Market Price
    • The market price is determined by face value, maturity and interest rate, but also the currency. Moreover, it is important to evaluate a bond based on the maturity yield of comparable bonds in the market. The actual market price is referred to as "clean", whereas when the price is adjusted for accrued interest, it is referred to as "dirty".
  • Yield
    • The yield is the expected rate of return for investing in the bond. The yield may be the yield to maturity - which is the expected rate of return taking into consideration the current market price and the time to maturity, or the current yield - which is the product of the division of the annual interest payment by the current market price. In fact, the yield to maturity is the internal rate of return of the bond, which represents the rate of growth that the bond is expected to generate.
  • Types of bonds
    • The following are the most commonly known types of bonds.
  • Government Bonds
    • Government bonds are issued by a government in its own currency. The idea is that, since the government can print more money to pay its debt in the local currency, it can decide how and when to meet its payments. Therefore, government bonds incur no risk. Moreover, the yield of government bonds determines the risk free rate of return, which represents the minimum return an investor would expect from a risk-free investment. On the other hand, there is the risk of defaulting under special circumstances such as extremely high inflation or unemployment. In this case, a government may choose to default and therefore it is safe to say that there is a sovereign risk involved in government bonds.
  • Corporate Bonds
    • Corporate bonds are issued by companies. The level of debt and maturity are determined by the current market conditions, but typically the term of a corporate bond can range between five and 12 years. Corporate bonds are much riskier than government bonds because any company can default on its debt and lose its physical assets that are often put as collateral for the bond. On the other hand, if the company's credit quality is high, corporate bonds can be the best investment choice because the interest rate is low and the yield is high.
  • Municipal Bonds
    • For investors with an average risk profile, municipal bonds are probably the best choice. Municipal bonds are issued by cities and are tax free. This makes them a relatively safe investment because a city rarely defaults. However, their yield is lower than a government or a corporate bond, which are both taxable.
  • Zero Coupon Bonds
    • Zero-coupon bonds are traded at a sharp discount below their face value. At maturity, they do not pay interest, but they pay higher return when redeemed for their full face value. However, because they pay at maturity, zero-coupon bonds are affected by market fluctuations throughout the term.

      In short, bonds are a safe haven for investors, especially in challenging economic times. They incur the lowest risk of any other investment vehicles and they pay at maturity.