Bonds have been around for hundreds of years. It’s how governments and corporations fund projects and the mainline of debt corporations take on.
A Bond is a loan
You’ll hear a lot of different lingo with bonds. Being called multiple other names, such as fixed-income, and debt securities. Once you start to grasp bonds and their function, these names make complete sense. Until then the best way to think of a bond is a loan
The loan is usually between the bond issuer (known as the borrower, since they issue the bond to borrow money) and the investor (known as the lender, since they lend to the bond issuer). The main issuers of bonds are either corporations or, state and federal governments. Let’s take a corporation as an example since they’re a little easier to understand.
Telstra needs some cash to fund a new project, so they issue some bonds through the bank. Investors don’t buy bonds directly off Telstra or any corporation/government. Banks act as a mediator between investors and bond issuers. So an investor buys the bond or lends Telstra the money, whichever way you want to look at it, they both mean the same thing with bonds. After the transaction, Telstra now has the money, and the investor has the bonds.
Now that investors have the bond what determined how much they paid for this debt?
The par value & maturity date
The price paid for the bond is called the par value or face value.
A bond issuer might issue some bonds with a par value at $1000; however, you can’t just buy one bond for $1000 they usually sell in parcels. So, you might have to purchase a minimum of 500 bonds if you want to invest directly. Often, retail investors don’t have the capital to invest directly into bonds; it can take an investment of a minimum $100,000 to buy bonds directly through the bank. But don’t worry, you can invest small amounts of money into bond funds, where the fund buys these bonds for you.
When a bond issuer, issues the bond it comes with a lifetime. For instance, they might issue the bond with a 10-year maturity date. What this means is, after the 10-years are up the bond is finished. Here’s the cool part, at the end of the 10-years you receive your entire initial principal amount back.
In the example above, I gave a bond with a par value of $1000. Let’s assume you could buy 1 bond with a par value of $1000. This bond you purchased has a maturity date in 10-years’ time. You buy this bond, and hold it for 10 years, at the end of the 10-years you receive your $1000 back. The terminology known as maturity date is the same for all bonds, every bond has a maturity date, and at the end of that maturity date, you’ll receive your principal back in full (assuming a corporation doesn’t go bankrupt of course).
There are all different types of bond maturities. Such as but not limited to, 3 month, 1-year, 10-year or 30-year maturities. Some smart person then decided to name them short-term, medium-term and long-term bonds.
The coupon rate
It seems strange that someone would lend their money out for potentially 30 years and receive nothing in return, but that’s not the case with bonds!
Bonds come with what’s known as a coupon rate; this coupon rate is also the pre-determined interest rate of the bond. Usually, the interest rate on these bonds is paid every 6 months. Or, they can sometimes pay quarterly. How high the interest rate is, is determined on how risky the country or company is (more on this later).
If you buy a 10-year bond with a coupon rate of 5%, you’ll receive 5% on your money every single year for 10-years, or if you buy a 30-year bond, you’ll receive 5% every year for 30-years.
Bond issuers must pay this interest rate; it’s their obligation by the law, unlike dividends, where the board of directors need to approve a dividend.
Let’s see how much you’ll receive with a 5% coupon rate
So you invested $1000 and bought 1 bond, this bond was issued with a coupon rate of 5% and pays every 6 months. We only bought 1 bond, so at the 6-month mark we receive a payment for $25 then at the next 6-month mark we receive another amount for $25 (5% of $1000 is $50). Giving us our 5% yield at 12 months of $50.
Here is what our payment schedule will look like
If you hold this bond till maturity, you’ll receive in total $500 worth of coupon payments. Then at the end of year 10, you’ll receive your initial $1000 principal amount back too.
Quick recap: par-value/face value, coupon rate and maturity date
Here is the recap of what makes up the bond
- Par value or face-value: Is the what the bond cost, if it has a par value of $1000 each bond is worth $1000. However, larger investors can only invest directly in these. As you’ll need to buy 500 to 1000 bonds at a time.
- Coupon Rate: Is the interest the bond comes with for the life of the bond. So, if you buy $1000 bond with a 30-year maturity date and a coupon rate of 5%, this means each year for 30 years you’ll receive 5% on your $1000, or you’ll receive back $50 each year.
- Maturity Date: Bonds will expire on a certain date. if you buy one, $1000, 30-year bond. Then at the end of the 30 years, your bond will expire, but you’ll receive back your initial principal of $1000, plus you would have received all your interest payments!
Credit Risk & Investment Grade Bonds- The Credit ratings
I mentioned earlier how depending on how risky the asset is will determine how much interest is paid from the bond.
The people who decide on this riskiness is the credit rating agencies. There are 3 major credit rating agencies, Standard and Poors, Moody’s and Fitch. The table below is what’s known as a credit rating table. All 3 agencies give different credit ratings, but they mean the same thing.
Take a look at row 4, Standard and Poors give an AA-, Moody’s provides an Aa3, and Fitch will give an AA. They mean the same thing! These agencies want to be unique in their grading, oh well not everything can be too easy.
The area we’ll focus on for now is row 10; you’ll notice on the right-hand side of the table anything below row 10 is considered non-investment grade. These are also referred to as junk bonds since they’re credit rating is, well, junk. Essentially all those ratings above row 10 are investment grade as determined by the agencies.
Investment-grade bonds are meant to be of the highest quality; they have a low chance of defaulting on their debt obligations and should be able to pay back their coupon payments easily. Once we start getting into that lower medium grade there’s a slight chance, they might not be able to pay back, or they might go bankrupt. But they’re still considered investment grade even if they’re lower medium graded corporations.
A corporations credit rating determines the coupon rate
If a corporation or country have a below investment grade credit rating, they’ll usually issue bonds with higher interest (coupon rates). These high coupon rates are because they have a higher probability of going bankrupt, and if they go bankrupt investors won’t get their principal amount back at the bond’s maturity date. Because of this risk, they’re taking on the bond demands a higher interest rate.
If the corporation or government have a high credit rating or investment-grade credit rating, then they’ll pay a low coupon rate since they have a low probability of going bankrupt. Because they have a lower likelihood of going bankrupt, it means there’s less risk, and when there’s less risk investors can’t demand a higher interest rate.
The relationship with bonds and coupon rates is really, high risk (below investment grade) =high coupon rate, and low risk (investment grade) = low coupon rate
This is a simple guide to get you started learning about this asset class and its terminology. You’ll find there’s plenty more to learn. Such as it can be traded on the secondary market like stocks and the coupon rate can also rise and fall with central bank interest rates.
There’s a narrative out there that you need an allocation of 60/40 or 70/30 Stocks to bonds depending on your age. Or, once your old enough to be entirely in bonds. The main reason for this is bonds are less volatile if you buy an Australian government bond fund or ETF this should be much less volatile and stable income. However, you’ll need plenty of money cause at the moment with these low-interest rates investment-grade bonds are producing a yield of only around 1-3% (3% is if you’re lucky).
Do you invest in bonds? Let me know in the comments below!