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.
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.
Bonds have different interdependent characteristics that determine their value:
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.
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.
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.