What are bonds?

By Abi Tyas Tunggal 4 March 2018 5 min read

Outline:

  • Bonds are ways for governments and businesses to raise money;
  • They deliver returns at an interest rate every year for the life of the bond;
  • They also trade on open markets where the price and yield move around.

(Bonds can be a headache, but if you understand them, they can be a useful way to see how markets think governments are performing.)


Bonds provide long-term funding for government and business expenditures.

When you invest in bonds, you are lending money to a government or business at an agreed interest rate over a period of time.

For example, an entity might issue $500 in bonds at 5% per annum over 5 years.

So you give the business $500, and in exchange it gives you $25 (5%) every year, and then at the end of five years, the business also gives you back the $500.

It's basically a government or business paying to borrow money and after the maturity date is met, that initial sum is returned to the bond owner.

If you ever hear an investor talking about "fixed-interest", they are likely referring to that fixed-interest rate (5% above) that needs to be paid out over the period of the bond.

Another example

The best way to understand how a bond works is to walk through the math.

Don’t worry, it’s not hard.

Let's say, the Australian Government issues bonds valued at $10,000, with a coupon rate of 5%. This is paid twice a year, with a maturity of ten years.

You buy one for $10,000, loaning the government your money, and collect $250 twice a year, for the next ten years. That’s a total of $5,000 over ten years.

If you keep your bond to its maturity, you get the $10,000 back, too.

Is it risky investing in bonds?

Generally, bonds are considered one of the safest investments because they are designed to give you your money back in full and then some.

And because governments often issue them, the liklihood of the government going broke is sometimes seen as less than a company.

That said, not all borrowers are created equal. A simple way to think about it is when you apply for a credit card, the issuer wants to know whether you will pay back the loan.

The credit card company wants to know your risk of default.

In Australia, an individual’s risk of default is measured through their credit score, a number based on an analysis of credit history at a point in time.

Based on your credit score, lenders decide whether to lend you money and how
much they lend you. They may even use it to decide what interest rate to offer you.

According to ASIC, the information used to calculate your credit score includes (but is not limited to):

  • Your personal details (such as age and where you live)
  • Type of credit providers you used previously (e.g. bank or utility company)
  • Amount of credit you have borrowed
  • The number of credit applications and enquiries you’ve made
  • Any unpaid or overdue loans or credit
  • Any debt agreements or personal insolvency agreements relating to bankruptcy

This information used to place you in a category from below average to excellent. With 'excellent' meaning, you are highly unlikely to have any adverse events harming your credit score in the next 12 months.

Do governments and businesses have credit scores?

Similarly, credit rating agencies like Standard & Poor’s or Moody’s, give most governments and businesses a credit rating to help investors understand their risk of default. (i.e. their ability to pay you the yearly payout as well as the full repayment at the end.)

Like your credit score, Standard & Poor’s have their own categories, from D to AAA for long-term bonds. With D meaning an issuer has failed to pay one or more of its financial obligations (rated or unrated) when it became due. And AAA meaning the issuer has an extremely strong capacity to meet its financial commitments.

The worse the rating, the riskier the debt.

Just like a bank or credit card company uses your credit score to determine whether to lend to you, you can look at credit rating agencies to determine if you would like to invest in an
entity’s debt.

Investors call bonds over a certain rating Investment Grade — Investment Grade bonds generally pay a lower rate of interest, because it's less likely they will default.

Alternatively, a bond that has a higher likelihood of default is called a distressed or “junk” bond.

Due to the higher risk of default, junk bonds usually have a higher interest rate to encourage investors to loan the entity money, despite the higher risk of default.

For governments and businesses, it becomes less expensive to borrow money when they are more likely to pay the money back. This may be true for people too, as banks may offer you a more attractive interest rate if they think you’ll pay them back.

What’s a coupon rate?

The coupon rate, when you are talking about bonds, refers to the annual interest rate paid on the bond relative to the bond’s par value. Par value (or face value) is the value of the bond on the maturity date. This is the what value of what you originally paid.

The maturity date is simply the day you get the money you put in, back or the day your loan is repaid. The maturity date can vary from a few months to 100 years.

Most bonds will have payments of interest paid at a predetermined rate and schedule, remember they are fixed-interest securities.

Like stocks, bonds began their life as pieces of paper, rather than electronic transactions. The bond came with coupons that you would tear off and redeem, hence the name coupon rate.

Understanding bond yield

Bonds trade on an open market just like equities.

Even if you bought your bonds and are receiving your yearly payments, you can sell them to someone else who will then start receiving the fixed-interest payments and the end face value too.

As bonds can be bought and sold at any time and prices can change based on the underlying fundamentals of the entity issuing the bonds, (ie. the market's thoughts about how likely the government or business are to repay), supply and demand is important.

When a bond is first issued, the yield is equal to the interest rate.

However, the yield of a bond will change as the price the bond is traded at changes. This results in an inverse relationship between the yield and its price.

When the price goes up, yields go down and vice versa.

When a bond is selling at a premium, it is trading above face value, and when it is selling at a discount it is trading at below face value.

The global credit market is about 3 times the size of the global equity market. Debt securities like bonds are fundamental to the economy. We hope this post helps you understand a little more about them.

What are bonds?