The investment world is divided into three major asset classes: equities, bonds and cash equivalents. Today, We offers you a summary of everything you need to know about bonds.
What is an obligation?
Bonds are fixed income securities issued by entities that wish to raise funds. When you buy a bond, you lend money to that issuer. This money is refunded in full at a later date (called the “due date”). In the meantime, it is also possible that the entity regularly pays you interest (called “coupons”). The holder knows the exact amount he will receive if he holds his bonds until maturity, which is why they are qualified as “fixed income” securities.
There are two main types of bond issuers: states, local governments or municipalities and companies. For these entities, bond issues are an alternative source of financing for bank loans.
What are the characteristics of a bond?
Bonds have different interdependent characteristics that determine their value:
- The face value is the amount of principal borrowed, which will be repaid in full at maturity. It is often confused with the course of the obligation, but these two concepts are different. The face value is an amount engraved in the marble, while the price can fluctuate over time depending on the supply and demand in the market. If a bond is trading at a price lower than the principal, it is said to have a “haircut”. Conversely, if its price is higher, it is called “premium”.
- The coupon : the coupon corresponds to the interest rates that the holder will receive at regular intervals as compensation for the amount originally loaned to the issuer. Zero coupon bonds may be issued from time to time. In this case, the issuer offers a discount to the sale and repays the securities at their face value, in order to attract potential buyers.
- Maturity (maturity) : This is the date on which the issuer must repay the principal to the bondholder. It usually oscillates between one and thirty years, but can sometimes be longer. For example, in 1993, Walt Disney Co. launched a show called “Sleeping Beauty”: with a maturity of one hundred years, the bonds will mature in 2093 and carry an annual coupon of 7.55%.
The price and yield of a bond are inversely correlated, meaning that when one increases, the other falls. In general, the longer the bond’s maturity, the more sensitive it is to price movements.
- Return on Maturity : This figure takes into account the value of the different coupons and the future price performance of the bond in relation to the original face value redeemed on the maturity date. The price and yield of a bond are inversely correlated, meaning that when one increases, the other falls. In general, the longer the bond’s maturity, the more sensitive it is to price movements.
What are the risks?
Bonds are often considered less risky than equities. When stock markets are very volatile, investors tend to rush to the relative safety offered by these securities. US Treasuries are generally perceived as “risk free”, as the United States is very unlikely to default on its debt. But this is not the case for all bonds: some can be very risky.
The predominant risk to bondholders is credit risk, which is the risk that the issuer will fail to pay coupons or repay principal at maturity. To allow investors to assess the risks of a bond, credit rating agencies issue ratings to issuers. The purpose of these ratings is to gauge their ability to honor their commitments. The three largest rating agencies are Moody’s, Fitch and Standard and Poor’s.
The predominant risk to bondholders is credit risk, which is the risk that the issuer will fail to pay coupons or repay principal at maturity.
The table below details the rating grids used by these agencies to assess the financial health of issuers:
The debt of issuers rated “AAA” or “Aaa” is considered to combine excellent quality and minimal credit risk. Luxembourg can boast of having this coveted “triple A”.
Bonds rated “Ba1 / BB +” or lower are in the speculative category. The risk of a defect is higher.
Normally, the more a bond is perceived as risky, the higher its yield spread. The spread represents the difference between two returns. For example, bonds issued by a large, financially healthy company tend to have a relatively small spread compared to US Treasuries. On the other hand, the securities of a more modest company whose finances are not in good shape will usually have a larger spread compared to US Treasuries.
Where are the bonds traded?
Bonds are traded on the bond markets. When an entity issues bonds to investors to raise funds, these securities are sold on the primary market. Then existing bonds are traded on the secondary market. It is also possible to invest in funds exposed to the bond markets.
In many cases, investors diversify their portfolios by buying different kinds of stocks and bonds, depending on their profile. In general, a defensive (or low risk) portfolio holds a lot of quality bonds. Conversely, riskier portfolios have more shares.
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