What exactly is a bond? What types of bond are there? A guide to the world of bonds
As you may have read in my summary post on Investments, a bond can be part of your investment basket. Professionally speaking: A bond is a negotiable instrument embodying a debt. That is, the issuer of the bond undertakes to pay the nominal value (the amount on the bond) and its predetermined interest (possibly other services, contributions) to the respective owner at the specified time and in the specified manner.
Characteristics of the bond
Businesses and states issue the bond to cover the required capital. Since they need capital here, the consideration for the bond can only be paid in cash or by bank transfer.
If you choose a bond, you are basically entitled to the interest that was offered for the bond, and you will also get your principal back at maturity. This is independent of the performance of the business and the amount invested. No matter how much you invest, you will not be entitled to run the business, nor will you become the owner. However, you do not have any control or membership rights.
Bonds belonging to the same series have the same creditor rights regardless of all other events. Thus, no matter how many times the bondholder has changed hands, the amount does not matter, nor does it matter what the circumstances of the issue were.
A series of bonds is not necessarily issued at the same time. There is also so-called continuous issuance. In this case, the bond will be issued with the same maturity date.
Usage of bonds
Many people confuse a bond with a bank deposit and believe that the interest rate on the bond is higher than that on the bank deposit, but it is just as safe.
In terms of risk, the bond is subject to the same rules as any other investment. That is, a higher return outlook typically involves higher risk. Thus, a bond is more of an equity-like asset in this respect.
Just as many people keep their money in government securities, you can use bonds issued by others (such as corporate bonds) as a stand-alone form of investment, being that you can achieve a positive result this way. On one foot, investing in just one direction is not advisable, even if it seems like a very good option.
Depending on whether you use the bond as a “value store” function and your sole purpose is to protect your assets from money deterioration, or, conversely, you are building capital, you can use the bond differently.
While in the first case, looking for a well-rated issuer, you invest most of your assets here and work a smaller portion, you can use bonds as a means of risk-sharing (i.e., to diversify your portfolio) in addition to higher-risk assets when building capital.
In addition, by monitoring the remaining term or at bond funds the recommended maturity, you can re-weight your investment in smaller and lower risk assets as you approach your target date.
Bond issuer rating
Because a bond embodies a debt, it works just like any other loan. Normally, you also look very carefully at who you are lending your money to and if you take out a loan, the bank will also consider whether to lend it to you.
The same is true for bonds. After all, in this case, you lend to the issuer of the bond. The rating of the issuing company or state will help you with this.
What does a credit rating mean?
Larger companies and states are evaluated on the basis of the stability of their finances. There are several rating companies, the three best known of which are Fitch, Moody’s and Standard & Poor’s.
You can read more about credit rating classes on Wikipedia.
The best-rated bonds are recommended for investment, after all, the issuer has a stable operation and is unlikely to become insolvent. You can also invest in bonds at the bottom of the list, which offer higher interest rates, provided the company or the state doesn’t go bankrupt until then.
How reliable is the rating?
Whatever rating company you rely on, all of them can rely on existing information, none of them have a sphere of magic. This is why major bond issuers are reassessed at regular intervals (usually annually). Nonetheless, an unforeseen turn in a company’s life can happen that can bankrupt even a very well-rated issuer.
Therefore, the rating is an extra piece of information for you to choose a bond for the level of risk you choose. The higher risk associated with a lower rating is usually associated with a higher interest payment. If the issuer still exists by then.
Just by looking at the probability that the issuer will go bankrupt, you will never see your money again: For the top rated, i.e. AAA rated issuers, only 1 in 1,000 will go bankrupt on average in the 10 years after the issue.
In contrast, for CCC-rated issuers, bankruptcy affects nearly one in two.
How can you invest in a bond?
You can invest in a bond when the bond is issued, or you can get it on the secondary market when a security that has already been issued is offered for sale by its owner at the current price.
Through a securities account
Given that a significant portion of securities are not necessarily printed today, it is definitely advisable to have a securities account. Through this, you can also buy individual securities as well as invest in mutual funds with bonds.
Through an actively managed mutual fund
A significant proportion of mutual funds are bond-based funds. These can be money market funds investing in government securities, but either a “traditional” bond fund with corporate bonds or mixed funds managed with equities. This way, you can choose from funds with the right time horizon and return prospects for you.
You can read more about the bond ETF in the article on index tracking funds. Creating a bond ETF is not impossible, although it is not that simple due to the lower turnover of bonds. As the bonds are no longer sold before interest is paid, they are more likely to wait for payment, so the bond ETF requires stock exchanges where the redemption of units is smooth even with lower turnover.
Basic concepts related to the bond
The smallest unit at which you can still purchase the bond.
Generally, government securities issued in domestic currency are understood as a reference for the bond market. The yields and risks of bonds issued by companies are compared to the yields available on government bonds.
Gross exchange rate
The sum of the net exchange rate and accrued interest.
New securities are issued and sold here.
A marketing technique in which investors can subscribe for a bond at a pre-determined rate.
Many people can issue bonds. Such can be the state (not only the state of Hungary, but the state of any other country), local governments, the central bank, or even companies. The issuer undertakes, on its own behalf, to repay the nominal value and interest of the bond to the investors in the manner and on time agreed.
A bond issued by the state is a government security.
The interest rate paid on the bond
The date on which the issuer also pays the face value of the bond
A bond is a marketable security, so the stock that is already in circulation can change hands at the daily exchange rate on the stock exchanges.
The value written on the bond or, in electronic form, the value for which interest is paid.
Net exchange rate
The current rate of the bond without interest.
Grouping of bonds
According to interest
Fixed rate bond
The interval between interest and interest payments is fixed at the time the bond is issued and does not change during the term.
Floating rate bond
The interest rate can vary depending on the elapsed time (eg it starts from 2% and increases by 1% per year until the end of the term) or it can be fixed to some external factor (eg current inflation + X%).
Variable interest rates are even called floating interest rates.
The bond is not repurchased, but an annuity is paid afterwards for an indefinite period (i.e., forever). This annuity can be fixed or it can be increased to a predetermined extent.
It is also called a discount bond. No interest is usually paid, but it is traded below par at subscription and is repaid at maturity. The benefit to investors is the amount between the purchase price and the face value.
By repayment method
In one amount at the end of the term
This is the easiest and most common way to repay. The full nominal value of the bond is repaid by the issuer to the holder in one amount at the end of the term. Then the bond also expires.
The issuer may also decide, in accordance with a pre-determined rule, to repay a part of the capital together with interest each year. This doesn’t necessarily happen from the first year, they may just start paying after the grace period has expired. Nor is it obligatory to follow a steady pace each year, it may be different. All this is recorded before the issue, so investors should not be surprised in this respect.
Along with the repayment of the principal, the interest rate usually does not change. Since the interest is always calculated on the principal and part of the principal has also been paid by the issuer, all the interest paid will obviously decrease. Thus, if the company has already repaid 10% of the capital, the interest will also decrease by 10%.
Fixed term bond
The simplest case of bonds. At the time of issue, the date on which the nominal value is due to be repaid is determined. Because it embodies a debt, the full amount of the loan is repaid by repaying the face value (i.e., the principal), at which point the bond is terminated.
Bond without maturity
The perpetual annuity bond mentioned above is included here. It has no expiration date, so the principal will always be used for an interest payment.
Bonds with uncertain maturity
Special types of bonds are included here. In the case of callable and redeemable bonds, there is a possibility for be terminated before maturity.
The callable bond
Grants rights to the issuer. If market interest rates unfavorably for the issuer (e.g., the payable interest can’t be generated), the callable bond entitles the issuer to repurchase the bond before maturity at a predetermined callback rate.
The redeemable bond
This gives the bondholder the opportunity to redeem the it before maturity. (e.g., when money market interest rates are higher than the nominal interest rate on the security).
It is a relatively infrequent option, in which case the policyholder is given the right to convert the bond into a specified number of shares under certain conditions. At this point, the bond is terminated and the holder of the security no longer receives interest. Instead, he becomes the owner of the company and is entitled to a share of the company’s profits in the form of dividends.
In this case, either the tangible asset, an ongoing project or a financial portfolio is the collateral behind the bond.
Just as you can get credit in banks without real estate collateral, merely for credit for your stable solvency, so for bonds, the issuer has the option of leaving behind nothing but his own promise of payment.
The return is nothing more than the benefit of the investor. This is positive in the good case. In the event that you buy the bond at issue and hold it to maturity, the yield will equal the interest. If you trade with it, the bond will have a different yield than the interest you regularly get.
The effect of the exchange rate on yield
If I were to show calculations here, it would seem a bit complicated, but it is very simple: price goes up = yields go down.
Interest is always expressed in terms of nominal value, which is independent of the exchange rate at which you bought it. Suppose you have a bond with a nominal value of HUF 100, which pays 10% interest per year.
If you can buy this bond for HUF 90, you will still receive 10% interest on HUF 100. It’s like you got 11.11% interest instead of 10%. So it brought you more. On the other hand, if you paid 110 forints for that, you will only receive the amount corresponding to 9% interest.
When you buy the bond below face value, you get it at a discounted price. If you paid for it above face value, you gave a premium for it. If you buy it at face value, that is the par rate.
The image below shows the relationship between exchange rate and yield.
Over time, as the bond gets closer to maturity, the face value and purchase price get closer and closer, and so does the yield outlook.
This is a natural process that is independent of whether you are currently buying at a discounted price or at a premium. Thus, the price of a premium bond will continue to fall and that of a discount bond will rise.
Risk of this security
Finally, let’s say a few words about the risks you face if you choose bonds. As there are countless and one more risks that can be listed for any investment, we will now only review the most important ones.
I mentioned to you above that a bond embodies a debt, so it is important how stable the issuer is. If you buy a speculative bond, you can get out of it by getting a much higher interest rate until the end, but there is also a chance that you can run for your money.
Interest rate risk, duration
In the case of bonds, one of the most prominent risk factors is interest rate risk. The question here is how much the price of our bond changes, and thus the yield, in the event of a change in the interest rate (eg when the central bank changes the interest rate).
Interest rate sensitivity is a kind of measure of duration. It could be translated as remaining time or average time, but these are not the exactly the same as duration. The longer the average remaining time, i.e. the duration of the bond, the more the change in the interest rate affects the bond.
So if you expect interest rates to fall, choose a bond that has a long remaining term. Then your exchange rate will also rise and you can get a higher interest rate for a longer period of time. In the event of a rise in interest rates, give preference to bonds with shorter durations.
Exchange rate risk
This occurs, on the one hand, in the event of sudden market changes or, for example, when credit rating agencies downgrade a state from a level recommended for investment to a speculative, risky level.
Many mutual funds hold some of their money in bonds, and if their investment policy does not allow them to hold money in speculative securities, they have to sell it. This, in turn, can lead to significant oversupply and thus to a fall in the exchange rate.
- On what basis do you choose / would you choose a bond for yourself?
- How would you use bonds in your own portfolio?
- How long do you think it is appropriate to keep bonds in general? (That is, how often would you review your portfolio?)
Choosing the right investment tool for your goals is not an easy task. If you are not familiar with it, ask us for help, you can contact us here.