What is a bond?
A bond is a type of debt instrument issued (sold) by a government, company, corporation, or local authority to raise money for projects and operations. Put differently, when investors buy bonds from bond issuers, they provide small loans to the issuers.
Key terms regarding the trading of bonds
To be successful in bond trading, an investor has to take note of the following key terms (in alphabetical order) concerning bonds.
- Basis points (BPS): BPS is a common unit of measure to indicate changes in a bond’s yield. One basis point reflects a 0.01% change and a 1% change = 100 basis points. For example, when a bond’s yield increases from 7% to 7.5%, it moves 50 basis points, which equals 0.5% (50 BPS x 0.01%).
- Bid: The amount an investor is willing to pay for a bond.
- Bid-offer spread: Basically, the difference between the highest price (the bid) that a buyer is willing to pay for a bond and the lowest price (the offer or ask price) that a seller is willing to sell the bond for.
- Bondholder: The entity or individual who purchases the bond. Also called bond owner, lender, purchaser, or creditor.
- Bond issuer: The government or other entity that issues (sells) the bond. Also referred to as borrower or issuer.
- Coupon or coupon rate: The interest rate paid by the bond issuer to the bondholder. Typically, a fixed rate that is based on the face value of the bond, expressed as a percentage. For example, a bond with a face value of R1 000 and a coupon of 9% means that a bondholder will receive interest of R90 per year.
However, nowadays, variable interest rates are also quite common.
- Coupon dates: The dates on which the bond issuer will pay interest. Typically, interest is paid every six months.
- Current coupon: Refers to a bond that trades close to its face value. Expressed differently, it indicates a bond that trades at a yield that is within ± 0.5% of current market rates.
- Discount: When a bond trades for less than par value.
- Face value: The amount a bond will be worth when it reaches maturity, payable to the bondholder. It is also the amount used by the bond issuer to calculate coupon (interest) payments.
It is also known as the par value or the principal.
- Issue price: The price at which the bond issuer initially sells the bonds.
- Maturity date or simply called maturity: The date on which the bond will mature, and when the bondholder will receive an amount, represented by the face value of the bond, from the bond issuer.
- Price or bond price: The price that an investor is willing to pay for an existing bond. Usually, a bond price is indicated as a percentage of par value. For example, when a bond’s par value is R1 000 and its price is published as 95%, it will be sold at R950. Likewise, 105% (or R105) equals R1 575 per R1 500 bond.
- Premium: When a bond trades for more than face value.
- Offer or ask: The amount a trader or investor is willing to sell a bond for.
- Yield to maturity (YTM): The total return a bondholder can expect to receive if a bond is held to the maturity date.
Categories of bonds
Usually, bonds can be classified into three primary categories, namely:
Government bonds
These are bonds issued by governments and are also called sovereign debt. Typically, in developed countries these bonds are considered ‘risk-free’ because they are backed by the credit of a stable and financially strong government, meaning that it is always anticipated that these governments will not default in payment of debts.
Interest on government bonds is generally lower in relation to other fixed-income financial instruments.
Corporate bonds
Corporate bonds are issued by companies. They carry more risk than government bonds but provide a higher yield.
Convertible bonds and callable bonds are two specific types of corporate bonds.
Municipal bonds
Bonds that are issued by local authorities, such as municipalities and cities.
Types of bonds
There is a wide variety of bonds available for investors, such as:
Fixed-rate bonds
A fixed-rate bond is the most common type of bond, with a coupon rate that stays the same until the maturity date of the bond. This means the bondholder receives a fixed income for the duration of the bond.
Commonly, two risks linked to fixed-rate bonds are inflation and interest rate volatility.
Floating rate bonds
A floating rate bond, also referred to as an inflation-indexed bond, is a bond tied to some benchmark rate, such as the repo rate of a central bank or the inflation rate of a country.
This is a type of bond that counteracts the effects of inflation and interest rate volatility.
Zero-coupon bonds
Instead of paying interest (coupon payments), these bonds are issued at a substantial discount to their face value. U.S. Treasury bills are a zero-coupon bond.
An investor’s return is generated by the amount of the discount received. For example, if you buy a U.S. Treasury bill with a face value of $2 500 for $1 800, at maturity you will receive the par value of $2 500 and your gain will be $700 ($2 500 – $1 800).
Zero-coupon bonds are also referred to as strip bonds or strips, as the coupons are stripped from the bond and can be traded separately from the bond itself.
Strip bonds are more volatile than fixed-rate bonds.
Convertible bonds
Issued by companies, a convertible bond includes an option, enabling a bondholder to convert a bond into a certain number of shares of the company. The option depends on certain conditions, such as the share price at the time of the conversion.
They are considered hybrid securities because they have combined debt and equity features.
Callable bonds
A callable bond is also a type of corporate bond. It can be redeemed by a company before its maturity. Usually, this is done when interest rates decline to a level lower than when the bonds were originally issued. A company will call back (buy back) the original bonds from the bondholders at their face value and then reissue bonds at a lower coupon rate.
A callable bond is riskier and not as valuable as fixed-rate bonds. Therefore, investors will normally demand extra compensation when they buy callable bonds.
Puttable bonds
A puttable bond, also called a put bond, is a bond that gives a bondholder the right, but not the obligation, to put back (sell back) the bond to the bond issuer before it has matured.
It is beneficial for an investor who is concerned that a bond will decrease in value and who wants to get his or her money back before it actually happens. A put bond usually trades at a higher face value than a bond without a put option.
For the bond issuer, it is usually a cheaper source of financing because the bond is issued at a lower coupon rate.
Perpetual bonds
Also called perpetuities, consol bonds, or preps, perpetual bonds are bonds with no maturity date. Although not redeemable, they pay interest at regular intervals forever.
How to start trading with bonds
When deciding on which bonds to invest in, firstly assess your personal needs and investment goals, like: Generating profits, obtaining a steady source of income, or protecting your investment portfolio.
Bonds are traded on the bond market, also referred to as the debt market or credit market. The bond market is not a centralised location but an over the counter (OTC) market.
New bond issues are put up for trade on the primary market, and any subsequent trading takes place on the secondary market, enabling investors to buy and sell bonds already owned.
Regarding the trading of bonds in South Africa, investors have, inter alia, the following possibilities:
- They can access the following bonds through the Debt Market of the Johannesburg Stock Exchange (JSE):
- Government bonds.
- Corporate bonds.
- Green bonds – According to the JSE: ‘With JSE Green Bonds, issuers can raise the capital they need to bring their green investments to life.’
- Repo bonds – An opportunity for traders (speculators) to ‘go short’ on the bond market.
- Trade through a certified, experienced, and reliable broker.
- Buy government bonds through reputable financial institutions, such as banks.
Nowadays, bonds can also be traded through bond exchange-traded funds (ETFs). There are bond ETFs for all the main types of bonds, such as government, corporate, and municipal, to name but a few.
Bonds versus stocks
Generally, investors are advised to diversify their investment portfolios between stocks and bonds.
Bonds and stocks are two different methods a company can use to raise money to fund current operations or to expand its operations.
So, before investing in stocks or bonds, or in both, it is beneficial to take note of the fundamental differences between the two types of securities.
Stocks
Simply put, stocks represent shares of a particular company. When an investor buys shares of a company, he or she buys a portion of the company and becomes a partial owner, albeit a small owner. That is why stocks are also referred to as equity.
As partial owners, investors share in the profits and losses of a company. If a company performs well and its worth increases over time, investors will benefit from that. However, an underperforming company’s share price could fall, causing losses for shareholders. The worst-case scenario is that a company could go bankrupt, effecting an investor to lose his or her entire investment in the company.
Because of the nature of stock trading, stocks are often a riskier short-term investment than bonds, given the amount of money an investor could lose in a short period of time. Although in the long term, stocks have historically proved to be extremely valuable investments.
After a company’s shares have been sold via an initial public offering (IPO), they are traded globally on different stock exchanges.
Bonds
Bonds represent debt. When issuing a bond, the issuer is issuing debt with the undertaking to pay interest on the amount (face value) borrowed and to pay the amount borrowed back at its maturity date.
Bonds guarantee a fixed income over a period of time and they are in general less risky than stocks. However, they lack the long-term potential of stocks.
Bonds are generally not sold on localised exchanges but are mainly sold over the counter (OTC).
Some risks involved in bond trading
Although bonds are generally observed as safe investments, they do carry their own risks.
Credit risk
Credit risk, also called default risk, refers to a situation when a bond issuer is unable to pay the interest or principal on a bond in time or at all.
Credit risk can be managed by confirming an issuer’s bond rating before buying a bond. Credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch provide credit ratings for bond issuers. The riskier the investment, the lower the rating. When an issuer’s credit rating dips below a certain level, its bonds are considered ‘junk bonds’.
Inflation risk
Inflation risk occurs when the inflation rate in a country rises to such an extent that the returns associated with a bond are reduced. It has the greatest effect on fixed-rate bonds.
Liquidity risk
Investors in bonds also face liquidity risk, especially with regard to corporate bonds. This is the risk that a bondholder might not be able to sell his or her bond without delay due to a thin bond market, characterised by a low number of sellers and buyers, reflecting lower liquidity in the particular market.
Low buying interest can cause considerable price volatility, forcing an investor to sell his or her bond at a lower price than the expected selling price.
Interest rate risk
Interest rate risk is one of the two main risks regarding bonds, the other one being credit risk. The longer a bond’s duration, the greater its interest rate risk.
There is an inverse relationship between market interest rates and bond prices. When interest rates increase, bond prices tend to fall and vice versa.
For example, high interest rates tend to make bonds less attractive for investors because they have other investment opportunities with higher returns at their disposal. A bond with a falling price will trade at a discount, reflecting the lower return the investor will make on the bond.
Conversely, an originally issued bond would trade at a premium above par value when it offers an interest rate (coupon) that is higher than the coupon payments offered on new bonds.
Note: This article does not intend to provide investment or trading advice. Its aim is solely informative.
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