What is a Bond?
A quick post on bonds this week before we head into the second half of summer. Bonds probably deserve a much lengthier post but we can get started with a short post on the basics. On a total market value basis, bonds are more prevalent than any other method of raising capital or money worldwide (greater than raising money through the stock market as an example). So what exactly is a bond? Are they the financial instruments you buy from the government for low risk and low interest rates? Yes, but the bond market encompasses many more issuers and investors. A bond, also known as a fixed-income security (I will explain why it is called that later), is essentially a loan given by an investor to the government, company or other type of bond issuer. The bond issuer is borrowing money from you, the investor, for a set interest rate or return. The issuer of the bond is contractually agreeing to pay you fixed or promised payments, hence the name, fixed-income.
A fixed-income or bond is not a claim of ownership on a company like buying a stock or share. A bond allows the investor a claim on the company's earnings and assets which is not something stock ownership provides. This can be seen as a lower risk investment depending on the state of the company. There are five main features of bonds that you should be aware of: issuer, maturity, par value, coupon rate and frequency, and the currency denomination. Let's briefly look at these:
1. Issuer - many sorts of entities can issue bonds but they can be grouped into three main groups government, corporations or specialized entities created for the purpose of issuing bonds. Even David Bowie in 1997 created a bond after which further "celebrity" bonds followed suit! As bondholders or investors are subject to credit risk (risk of loss from failing to make timely payments of interest and/or principal amount), bond markets are often sorted into sectors based on the credit worthiness of the issuer as judged by credit rating agencies. Investment-grade bonds are seen as lower risk than non-investment-grade bonds (speculative or junk bonds) that are seen as much higher risk.
2. Maturity - the date when the issuer is obligated to pay the principal amount outstanding. Maturity dates can range from overnight to over 30 years.
3. Par Value - the amount of the bond issuer is agreeing to pay the investor or bondholder on the maturity date.
4. Coupon rate and frequency - the interest rate the issuer is agreeing to pay the bondholder until the maturity date.
5. Currency denomination - bonds can be issued in any currency so that may have an impact on whether it is a strong investment. For example, an issuer in a developing country may have trouble attracting interest in its home currency bond so it may choose to offer the bond in a more widely recognized currency such as USD or Euros.
The above features are the main things you want to pay attention to when considering investing in a bond. They will allow you to determine the expected and actual return of the bond. One metric used to determine bond return that is analogous to the dividend yield of a stock is the current or running yield of the bond. This is calculated by dividing the bond's annual coupon by the bond's price to get a percentage yield on the bond. Safe bonds have lower yields whereas junk bonds, or high risk bonds, have higher yields to account of the fact the issuer is more likely to default on its obligations.
Because the bond is a legally, contractual agreement between issuer and bondholder, you also must be aware of any legal, regulatory or tax considerations impacting the bond. As well, be aware of any contingency provisions impacting the bond's cash flows. So, bonds are not as simple and easy as one might expect - low risk, government bonds may be easy to navigate for beginning investors but as you move into higher risk, further education and assistance from a qualified professional is likely a must! There is a great deal to consider on what a first may look like a simple loan type agreement.