The financial world can often feel foreign to outsiders.
Especially given how much jargon is thrown around.
But there’s nothing complicated about finance, and sometimes all you need is a simple explanation of what, at first, sounds like a complicated topic.
We’re going to tackle one now.
In this article:
- What are bonds?
- How do they work?
- Why are they important?
What are bonds?
Ever taken out a mortgage? Or a loan of any variety?
Congratulations, you have issued a bond.
Well, in essence at least.
A bond is simply an agreement to repay a fixed (sometimes variable) amount at a certain date, or across many dates.
When a company issues bonds, they are essentially borrowing money from investors, and paying them back later. In the same way you borrow money and pay it back later.
When a company does it, it’s known as a corporate bond.
Governments do it too.
If it’s only for a short time — up to a year — it’s known as a treasury bill.
If it’s for a medium length of time — from two to 10 years — it’s a treasury note.
How about a long time? Say, 30 years?
This is a treasury bond.
At their core, these are the same things.
The only reason they have fancy names is so that people can speak about each specific variety without having to be more descriptive.
Bonds can get more complicated and nuanced than this, but they all begin with the same simple concept.
Remember that loan you took out? You pay interest on it right?
In the ‘bond’ world, that interest is known as a coupon.
That’s because in the old days there was no online market. Investors received physical bond certificates, which had detachable coupons.
In order to claim the interest on the bond, an investor would present the physical coupon.
This meant that whoever had the physical copy of the bond could collect the interest.
Thus they were transferrable assets.
This method was good and bad, depending on whether you were a money launderer or the government.
These days it’s all electronic.
Corporate bonds can have different names depending on how the money is paid back.
If it’s all paid back at one point in time in the future without interest, it’s known as a zero-coupon bond.
The final sum received is usually larger with these bonds, as the investor has received no interest throughout its life.
Most bonds are secured (or backed) in the same way your mortgage is backed by the physical asset of your house.
For corporations, their assets are usually used as collateral for the bond.
This has more benefits which we will touch on later.
On the riskier side of things, unsecured bonds are known as debentures. Investors usually purchase these bonds on the assumption that the entity is unlikely to default on the repayment.
An example? Government bonds.
At worst, a government can simply print more money to repay debt.
Works well for Japan, right?
High quality bonds, or those with a high probability of being paid, are investment grade corporate bonds.
Low quality bonds are known as junk bonds. These offer higher yields as compensation for the higher risk that they will not be paid out.
We will get to yields in a little bit.
Foreign bonds are bonds in which the issuer promises to make payments in another currency.
If the payout is then converted back into the original denomination, they are subject to exchange rate risks.
A Eurobond is any bond issued and traded outside the country of which it is denominated in.
The reverse sometimes has interesting names, including:
Samurai bond: yen-denominated, issued in Tokyo by foreign corporations.
Bulldog bond: UK-denominated, issued in the UK by foreign corporations
Yankee bond: US-denominated, issued in US by foreign corporations.
Matilda bond: Surely you can guess this one?
The list goes on.
Foreign bonds serve an important purpose by allowing companies to access the capital markets in foreign countries.
Common reasons include more favourable interest rates on debt, or (in other words) a cheaper loan.
A company may also wish to hedge exchange risk present in the organisation.
Don’t forget governments issue bonds too, and trading in foreign government bonds is a key activity of reserve banks used to stabilise exchange rates and control the money supply.
Let’s skip forward.
How do they work?
Bonds can be bought and sold on the stock market.
Yet the majority of bonds are traded over-the-counter, which is a term given to securities traded by a network of dealers and brokers, rather than a centralised exchange.
The value at which a bond is initially offered is known as its par value.
This is typically $1000 or $100.
Bond coupons can be paid out monthly, quarterly, semi-annually, or annually. When the bond reaches the date of maturity, the principle is paid off.
So, what is the cost of buying a bond?
This depends on the coupon size (interest rate) at which the bond is offered at, and the prevailing rates in the market.
Let’s look at an example.
A corporation offers a $1000 bond that pays a $100 coupon annually for five years, after which the principle is returned.
This means the bond has an annual rate — or yield — of 10%.
But what if rates become higher across the street? Logically, if investors can receive more in return elsewhere, they go elsewhere.
In response, those wanting to sell the bond must do so at a lower price.
If the bond gets sold at $900, and the coupon remains at $100, the bond’s yield is now 11.11%.
On the other hand, if interest rates elsewhere in the market were falling, demand for the original 10% yielding bond would rise.
If demand rises, price rises.
Yet if the price paid for a bond rises, its yield falls.
If investors believe rates will rise in the future, they will avoid buying bonds until the price is sufficiently low that the effective yield compensates for this change.
The central point is that bond yields are subject to investor sentiment, current interest rates and expectations about the future.
For this same reason, investors expect a higher return for holding bonds with longer maturities, as any rise in market rates between now and maturity will devalue their investment.
More risk, more reward.
Why are they important?
Apart from the clear use of bonds by corporations and governments, investors have reasons to pay attention too.
Traditionally, bonds are seen by the market and economists as a more stable investment than equity (stocks). That’s because they often have collateral, and by holding bonds investors are in effect creditors and entitled to earlier payouts of a company’s assets in the event of liquidation.
They could offer income in the same way dividend stocks can.
As an alternative form of investment, bonds can also serve to diversify a portfolio, thereby minimising overall risk.
Bonds are also a form of managing interest rate exposure, as there is an inverse relationship between market interest rates and bond prices (as previously discussed).
There can also be some tax advantages to bond investing over shares. Investment bonds are taxed internally at a max of 30% (company tax minus franking credits etc.), rather than at owners marginal tax rate. After 10 years you can withdraw the bonds tax free.
Nevertheless, while the market typically believes that bonds are ‘less risky’, that may not be the case in practice.
Remember, interest rates are at a 30-year low worldwide, having peaked in the early 1980s when US interest rates shot up to 17–20%. Ever since this time, government bonds have been in a bull market, with pension funds investing funds into what’s perceived a ‘safe’ investment.
Unfortunately, in the real world, there isn’t anything ‘safe’ about bonds. Countless numbers of countries have defaulted on their national debts in history. Multiple emerging markets have defaulted on their debts in our life time. However, regarding the Western world, the most recent sovereign debt crisis occurred during the Great Depression in 1931.
Put differently, if another sovereign debt crisis happens in our life time, a country could default on your entire investment ― the exact investment you thought was safe.
Despite the oft-forgotten risks, the importance of bonds extends to those neither interested in buying or selling them. As previously mentioned, bonds can serve as a measure of market sentiment. As such, they have become important macroeconomic indicators.
If short-term bond yields start to rise (as consequence of a falling price), this can be an indication that the market expects interest rates to rise, or are generally uncertain in the short term.
A fascinating concept is yield curve inversion.
Yield curves are said to have inverted when short-term bonds have higher yields than long-term bonds.
In other words, investors expect more for having their money tied up in the short term than the long term.
And historically, inversions of the yield curve have preceded many recessions, which has lead yield curves to become a heavily analysed topic.
To surmise, by watching what happens in the bond market, you can receive early indications of what’s happening in the markets as a whole.