What are bonds?
What are bonds, what are the different types and what are the most important things investors should consider when investing?
The most important facts in brief
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1. Basics
Bonds (also often referred to as debentures) are securities that give the creditor the right vis-à-vis the debtor to repayment of the borrowed capital on the maturity date and payment of interest during the term. The maturity date, the term and the type of interest (fixed or variable) are determined before the issue. Issuers of bonds can be states, companies, banks, but also public-law corporations, for example municipalities.
In addition to the general interest rate level and the term, the issuer's credit rating also has an influence on the interest rate. The latter is assessed by rating agencies such as Standard & Poors (S&P) or Moody's. S&P's rating levels range from the highest credit rating AAA (triple A; low default risk) to D (D for default or non-performance; partial or complete default). For simplicity, a distinction is made between two types of bonds within the rating scale: Investment grade (S&P ratings: AAA to BBB-) and non-investment grade (S&P ratings: BB+ to D). The latter are often also referred to as junk bonds or high-yield bonds.
In contrast to the high volatility of equities (markets), bonds can be far less risky. In particular, the bonds of government issuers of industrial nations are often considered risk-free for investors of the same currency area. Bonds from companies with a rating at the upper end of the investment grade scale behave similarly. As maturity increases and/or creditworthiness decreases (synonymous with higher default risk), the risk profile changes and bond prices behave with increasing volatility. For example, high-yield bonds with a remaining term of ten years fluctuate significantly more than German government bonds with only two years remaining term.
For portfolios, bonds are primarily suitable as a risk-reducing component. Here, the interplay of risk and return becomes clear: compared to equity investments, the risks are lower, but so are the potential returns. Bonds are primarily used to diversify the portfolio and portfolios with a bond component are generally characterised by lower fluctuations.
Bonds can be traded on the stock exchange or over the counter (OTC). When trading, it should be noted that bonds are traded in percentage quotations (price = percentage of the nominal value). In addition, there is a minimum denomination, which, depending on the bond, can be 1,000 euros, 10,000 euros or even 100,000 euros. Due to the minimum denomination, direct investments in bonds are not suitable for many private individuals, especially since they often want to invest in a broadly diversified manner. Bond ETFs offer an opportunity to invest in various bonds in a broadly diversified manner, even with low amounts.
2. Characteristics and features
The nominal value or face value is the amount of money noted on the bond. It forms the basis for interest payments and indicates the amount of the creditor's claim against the debtor.
As with shares, the issue price of bonds can differ from the nominal value. A distinction is made here between the following issues:
- par: issue price = nominal value
- above par: issue price > nominal value (the difference is called premium)
- below par: issue price < nominal value (the difference is called a discount).
The present value is the sum of the present values of all interest payments and the present value of the repayment of the nominal value at the end of the term.
The coupon is expressed as a percentage per annum (% p.a.) of the nominal value and indicates the interest rate on the bond. The coupons can be paid annually, but also during the year - for example quarterly or semi-annually.
The term (or maturity) indicates the period over which coupons are paid and at the end of which the borrowed capital must be repaid. Unlike shares, bonds have a fixed term. A distinction is made between
- Short-term (up to three years),
- medium-term (three to ten years) and
- long-term (longer than ten years) bonds.
If you own a bond, you do not have to hold it until maturity, but can sell it during that time.
It should be noted that there are also bonds without a fixed term: So-called perpetual bonds are a special type of bond because they have no maturity date.
Another exception is zero coupon bonds, where the bond is purchased at a discount to the nominal value, depending on the interest rate, and the value of the bond increases to the nominal value towards maturity, before it matures at this value on the day of maturity.
Yield-to-maturity is the yield or interest rate received by those who hold the bond until maturity and reinvest the coupon payments accrued until then at the same interest rate until maturity.
Duration is the measure of how sensitive the price of a bond is to changes in interest rates. Long-term bonds have a higher duration than short- and medium-term bonds.
Ranking affects the treatment of creditors' claims in corporate insolvency proceedings. Claims of investors who have invested in senior bonds are serviced first and thus before subordinated claims from the insolvency estate. Accordingly, the risk of loss is higher when investing in subordinated bonds, which is reflected in higher potential returns. In this context, secured bonds offer additional protection in the event of a company's insolvency.
The characteristics of bonds with option rights, which among other things influence the timing of repayment, can be as follows:
- Callable (bond with debtor's call right)
A callable bond gives the issuer the right to call the bond early at any time after a certain period on one or more interest dates. Since the debtor has a right of choice, the option granted is a short call position on this bond from the investor's point of view. - Puttable (bond with creditor call right)
A puttable bond gives the creditor the right to call the bond early at any time after a certain period on one or more interest dates. Since the creditor has a right of choice, the option granted is a long put position on this bond from the issuer's perspective.
3. Opportunities and risks
Inflation risk - The inflation risk for investors is that the expected income from coupons and the nominal value of a bond will already be worth less at the time of payment compared to today, since fewer products and services can be purchased with it at that time. In principle, long-term bonds are exposed to a greater inflation risk than short-term bonds. This risk can be reduced with the help of inflation-indexed bonds, as the coupons and the nominal value are adjusted depending on inflation.
Interest rate risk - Interest rate risk is the risk of interest rate decisions by central banks. In principle, there is an inverse relationship between interest rate changes and the cash value of a bond: when interest rates rise, the price of a bond falls and vice versa.
Default risk - In contrast to shareholders, buyers of bonds do not acquire shares in the company, but are usually only lenders. In the event of the bond issuer's insolvency, creditors therefore receive priority treatment over shareholders (equity investors) in the insolvency proceedings. In general, the higher the default risk of an issuer, the higher the interest on the borrowed capital to compensate debt providers for taking on the increased risk.
Currency risk - Those who buy bonds denominated in foreign currencies are also exposed to currency risk. If the currency in which the bond is denominated appreciates against the home currency, investors additionally profit from the price development. Similarly, if the foreign currency depreciates against the home currency, the yield is reduced.
Liquidity risk - A high liquidity risk arises for bonds with low market breadth and depth. In this case, for example, sales are subject to high price markdowns due to a wide bid-ask spread. This particularly affects securities of smaller companies with low issue volumes, which are bought or sold by only a few market participants. In addition, if the issue date of the bond is far in the past, this has a negative impact on its liquidity. These "off-the-run" bonds are usually traded less than so-called "on-the-run" bonds whose issue date goes back less far.
It should be noted that the individual risks have different effects on the different maturities of bonds (in technical jargon, this is referred to as the yield curve). For example, higher inflation expectations tend to influence the middle and long end of the yield curve, while interest rate decisions by central banks have a stronger influence on the short end. According to theory, the yield curve reflects the interest rate level of short-term bonds in the future.
Default, currency and liquidity risks exist for all bonds rather independently of the maturity: relevant here are the creditworthiness of the issuers, the volatility of the corresponding currency pair and the market breadth and depth.
4. Types of bonds
The standard bond has a fixed interest rate over the entire term. At the end of the term, the bond is repaid at the nominal value.
The so-called zero coupon bond does not contain any coupon payments. As a rule, this type of bond is issued below the nominal value (below par) and the nominal value is repaid at maturity. The yield is the difference between the issue price and the redemption price.
Perpetual bonds are bonds without a maturity date. Here, an investor receives constant coupon payments that are paid out indefinitely. One of the oldest perpetual bonds still being paid out is a Dutch perpetuity, which was issued in 1648 and is currently owned by Yale University.
The annuity bond differs from the standard bond in that in this type only a constant amount (the annuity) is repaid on a regular basis. This already includes the coupon and the redemption amount of the bond. Thus, the nominal amount is repaid over the individual annuities until the end of the term and there is no one-off payment of the nominal value on the maturity date.
A collateralised bond is a bond secured by assets of the issuer that provides protection against the risk of default. In the event of default, the creditors' claims are serviced from the assets that have been separately deposited as cover and thus do not form part of the insolvency estate. This greatly minimises the default risk, which is reflected in comparatively low interest coupons.
In the case of a floating-rate bond (floater), the interest rate can change during the term, as it is linked to a reference interest rate plus a contractually fixed premium for the issuer's creditworthiness. In practice, reference interest rates can be the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), the U.S. Treasury note rate or the Federal Reserve funds rate. Investors can profit from rising interest rates with this type of bond, as the interest rate on the floater also rises or is adjusted periodically.
The inflation-indexed bond offers protection against inflation because the coupon and nominal value are linked to an inflation index (e.g. the consumer price index). In the event of rising inflation, no real yield or purchasing power is lost. It should be noted that in the event of deflation, the interest payments decrease. This type of bond is issued by governments.
Bonds with option rights:
- A convertible bond gives investors the right to exchange their bonds for shares in the issuer. Repayment is 100 per cent at par and coupon payments are made during the term. The conditions for the exchange are set in advance at the time of issue. If the share price rises above the conversion price, the bond can be exchanged for a certain number of shares. In a narrower sense, a convertible bond can also be considered a bond with a call option due to its characteristics.
- A warrant bond differs from a convertible bond in that the right to purchase the company's shares can be traded and exercised separately from the bond.
- The reverse convertible bond offers the issuer the right to either repay 100 per cent of the nominal value at maturity or to deliver a predetermined number of shares to the creditor at the time of issue. Compared to the standard bond, higher coupon payments can be expected here, as this type of bond combines regular interest payments with the price risk of a share.
Markus Kirchler
Markus is a Senior Analyst in the Capital Markets team. His main areas of expertise are portfolio management and ETP trading. He holds a Bachelor's degree in Economics from the Free University of Bolzano.
