What is a bond?

Also known as 'fixed income' instruments or 'debt securities', bonds are generally thought to carry a lower risk among 'real' financial assets.

A bond is basically a debt instrument issued by governments and companies to raise required financing. The issuer of a bond is effectively a borrower who wants to raise money from investors who are willing to lend them. The issuer is required to pay interest (known as coupon) to the investors throughout the life of the bond and return the money borrowed (principal) upon the maturity of the bond.

The larger the risk associated with the entity borrowing the funds, the larger will be the compensation for the investor in the form of interest/coupon payments.

Types of bonds

  • Sovereign Bonds

These are issued by national governments around the world - in the UK for example these are commonly referred as 'gilts' and are often described as 'risk free'. Their risk-free status reflects the low probability that the UK government would ever default. Generally speaking, these Government bonds can be issued by any country in the world however bonds issued outside the developed world are usually referred to as ‘Emerging Market Debt’ (see below).

  • Corporate Bonds

Corporate Bonds are debt securities issued by private and public corporations. Companies carry a higher degree of risk than the government and as such, pay higher interest rates. These are generally classified by credit rating agencies as either 'investment grade' or 'high yield/non-investment grade'. The latter are offered by companies with a less certain financial status and will pay higher income. 

  • Emerging Market Debt

These are issued by governments or corporations in emerging markets countries like India, Russia, South Africa and Brazil. These tend to be less stable than developed economies and to this respect carry a higher degree of credit risk which in turn provides a higher interest rate.

  • Convertible Bonds

These are corporate bonds which may be redeemed for a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder.  This is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock..

  • Callable Bonds

Callable bonds are corporate bonds which can be redeemed by the issuer prior to maturity. The main cause of a call is a decline in interest rates. If interest rates in the markets start to decline since a company first issued the bonds, it will likely want to refinance this debt at a lower rate. In this case, the company will call its current bonds and reissue new, lower-interest bonds to save money. Due to this additional risk for the investor, the callable bond is issued with a higher coupon rate than a traditional bond.

  • Unsecured/Secured Bonds

Unsecured bonds are those which do not have any other assets that serve as collateral should the company fail. Unsecured bonds naturally carry more risk than secured bonds; consequently, they usually pay higher interest rates than do secured bonds.

  • Subordinated Bonds

Subordinated debt, also known as junior debt, is debt which ranks after other debts if a company falls into liquidation or bankruptcy. Therefore, subordinated debt holders won't be paid out until after senior debt holders are paid in full.

  • Zero-coupon Bond

A zero-coupon bond is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full-face value. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price much more than coupon bonds. These are generally issued to avoid imposing an ongoing drain on cash flow in the form of ongoing interest payments. These can be issued by both governments and corporations.

Bond characteristics

  • Face/Par value

This is the value that a bond is issued for at the time and is also the amount of principal the bondholder will receive at maturity. The majority of corporate bonds are issued with a face/par value of $100 or $1,000 but this may vary by the issuer.

The face value of a bond should not be confused with the price of a bond observed in the market – the face value is always a given amount, while the price of a bond will fluctuate over time.

If the market price of the bond is lower that the specified face/par value, the bond is said to be trading at a discount. On the other hand, if the market price is higher than the face/par value, the bond is trading at a premium.

  • Coupon/Yield

This is the interest rate the issuer agrees to pay to the bond holders. Interest can be paid annually, semi-annually or quarterly. Bonds generally have a fixed rate of interest however there are those which offer a floating rate which his tied to a particular benchmark (e.g. Treasury bills, LIBOR, etc).

Some bonds do not pay a coupon at all (zero-coupon bonds), but are instead sold at an initial discount to be repaid at the full face value at maturity, which has the same net effect as paying interest on a bond sold at face value.

The coupon paid is determined by three factors; the current interest rate environment, the inflation expectations and finally the probability of getting paid at maturity or not.

  • Maturity

This is the date when the principal comes due and the issuer must pay it back in full to the bondholder. Maturities can range from as little as one day to as long as 30 years. A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, the longer the time to maturity, the higher the interest rate. Also, a longer term bond will fluctuate more than a shorter term bond.

  • Yield to maturity (YTM)

This is the total return one is to expect from the bond if such instrument is kept until it matures. YTM takes into consideration the present value of a bond's future coupon payments. Unlike the current yield, which is the annual interest/dividend divided by the current price of a security, the calculation of YTM is more complex as we need to factor in how much the investor would be earning by re-investing every coupon payment until maturity.

  • Duration

One of the most important characteristics of a fixed income security is duration. First, it's important to understand how interest rates and bond prices are related. The key point to remember is that rates and prices move in opposite directions. When interest rates rise, prices of traditional bonds fall, and vice versa.

Duration is the sensitivity of a bond’s price to changes in interest rates. As a simple example, for every 1% increase or decrease in interest rates, a bond’s price will change approximately 1% In the opposite direction of duration.

If a bond has duration of 5 years, and interest rates increase by 1%, the bond price will decline by approximately 5%. Conversely, if a bond has a duration of 5 years and interest rates fall by 1%, the bond’s price will increase by approximately 5%.

Duration is measured in years. Generally, the higher the duration of a bond or a bond fund (meaning the longer you need to wait for the payment of coupons and return of principal), the more its price will drop as interest rates rise.

Given its relative ability to predict price changes based on changes in interest rates, duration allows for the effective comparison of bonds with different maturities and coupon rates. For instance, a 5-year zero coupon bond maybe be more sensitive to interest rates than a 7-year bond with 6% coupon.

Understanding duration is very important for the investor. If, for example, you expect rates to rise, it may make sense to focus on shorter-duration investments (in other words, those that have less interest-rate risk).

Things to keep in mind about duration:
- The duration of any bond that pays a coupon will be less than its maturity, because some amount of coupon payments will be received before the maturity date.
- The lower the coupon, the longer the duration because proportionately less payment is received before final maturity (and vice versa).
- A zero-coupon bond makes no payments and has its duration is equal to its maturity
- The longer the maturity, the longer its duration because it takes more time to receive full payment. The shorter the maturity, the short its duration because it takes less time to receive full payment.

Duration
  • Convexity

Duration assumes a total linear relationship between bond prices and changes in interest rates. In actual fact however, prices fall/rise at an increase rate as interest rates rise/fall.

This disparity implies that duration will consistently overestimate the amount of price decline associated with a large upward move in interest rates. Conversely, duration will consistently underestimate the amount of price increase associated with a large drop in interest rates. In order to compensate for this disparity, the concept of ‘convexity’ was developed. Convexity corrects for the error that duration produces in anticipating price changes given large movements in interest rates. As such, convexity also measures the rate of change in duration, thereby fully accounting for the dynamic relationship between prices and rates.

Convexity can help you anticipate how quickly the prices of your bonds are likely to change given a change in interest rates. Everything else being equal, you may find issues with greater convexity more attractive, as greater convexity may translate into greater price gains as interest rates fall and lessened price declines as interest rates rise.

Risk associated with bonds

  • Credit or Default Risk

This is the risk that the issuer will be unable to meet his obligations, that is, will not be in financial position to make interest or principal payments when they are due to the investor. Rating agencies such as Moody’s, Standard & Poors (S&P) and Fitch assess the credit worthiness of issuers and assign a credit rating based on their ability to repay its obligations. Bond ratings range from AAA, which are generally assigned to governments in developed economies to CCC or lower which are considered as more likely to default.

The adjacent show the different risk scales applied by the major credit rating agencies. If we take S&P as an example, a bond with a rating between AAA to BBB- is considered an investment grade bonds whilst those with a lower rating are considered as ‘high yield’, ‘non-investment grade’ and sometimes as ‘junk’ bonds. A blue-chip company which has good financials will be generally rated as investment grade whereas a company which is facing financial difficulties will be rated as ‘high yield’ and in fact will generate a higher level of coupon.

  • Interest Rate Risk

Generally, when interest rates rise prices of traditional bonds will fall. This reflects the ability of the investor to find higher interest rates on their investments elsewhere.

Before investing in bonds, you should assess a bond’s duration (short, medium or long term) in conjunction with the outlook for interest rates, in order to ensure that you are comfortable with the potential price volatility of the bond resulting from interest rate fluctuations.

  • Inflation

This is the general increase in prices of any goods and services and therefore reduces the purchasing power of money. Bonds tend to be affected by changes in inflation due to the fact that this will have an effect on the principal/interest when received. A rise in inflation may lead to higher interest rates which is negative for bond prices.

  • Liquidity Risk

This is the risk that investors will not be able to find a buyer when they want to sell their bonds and will sometimes be forced to sell at a discount. This risk is mostly evident for bonds issued by smaller firms or bonds which are considered speculative. To minimise this risk, investors may wish to opt for bonds that are part of a large issue size and also most recently issued. Bonds tend to be most liquid in the period immediately after issue. Liquidity risk is usually lower for government bonds than for corporate bonds. This is because of the extremely large issue sizes of most government bonds.

  • Re-investment/Call Risk

When interest rates are declining, bond holders have a risk since they will not find similar bonds which generate the same level of interest. This therefore mean in order to achieve the same level of yield as before, bondholders need either invest in bonds which provide a lower rate or else invest in bonds which would be riskier.

For callable bonds an issuer has the option to call (redeem) the bond in advance and hence investors might face this risk beforehand should interest rates decline.