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Understanding Bonds
Overview
Bonds are a core element of any financial plan to invest and grow wealth. If you are just beginning to consider investing in bonds, use this section as a resource to educate yourself on all the bond basics. In this section you will learn:
- what a bond is
- why financial professionals recommend that you have bonds in your diversified investment portfolio
- key factors to consider when evaluating a potential bond investment
- fundamental strategies for investing in bonds
- about tools and aids that will help you understand bonds
What Are Bonds?A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, corporation, or other entity known as an issuer. In return for that money, the issuer provides you with a bond in which it promises to pay a specified rate of during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due.
Among the types of bonds available for investment are: sovereign government securities, corporate bonds, mortgage- and asset-backed securities. Market practices described here apply to the Irish bond market, and may differ from those in other countries.
Why Invest in Bonds?Many personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. Whatever your investment goals, your investment advisor can help explain the investment options available, taking into account your income needs and tolerance for risk.
Typically, bonds pay interest annually, which means they can provide a predictable income stream. Many people invest in bonds for that expected interest income and also to preserve their capital investment. Understanding the role bonds play in a diversified investment portfolio is especially important for retirement planning. During the past decade, the traditional defined-benefit retirement plans (pensions) have increasingly been replaced by defined contribution programs. Because these plans offer greater individual freedom in selecting from a range of investment options, investors must be increasingly self-reliant in securing their retirement.
Whatever the purpose—saving for your children’s university education or a new home, increasing retirement income or any of a number of other financial goals—investing in bonds may help you achieve your objectives.
Key Bond Investment Considerations
Assessing RiskAll investments carry some degree of risk, which is linked to the return that investment will provide. A good rule of thumb is the higher the risk, the higher the return. Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history and credit ratings. Together, these factors help determine the value of your bond investment and whether it is an appropriate investment for you.
PriceThe price you pay for a bond is based on a whole host of variables, including interest rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds normally sell at or close to par(100 percent of the face, or principal, value). Bonds traded in the secondary market, however, fluctuate in price in response to changing interest rates, credit quality, general economic conditions, and supply and demand. When the price of a bond increases above its face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
Interest RateBonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Fixed rate bonds carry an interest rate that is established when the bonds are issued (expressed as a percentage of the face amount) with payment typically in semiannual or annual installments. For example, a €1,000 bond with an eight percent interest rate will pay investors €80 a year, in payments of €40 every six months. This €40 payment is called a coupon payment. When the bond matures, investors receive the full face amount of the bond, €1,000. (Plus any coupons due) Some issuers, however, prefer to issue floating rate bonds, the coupon of which is reset periodically with reference to a benchmark interest-rate plus a margin. The margin is determined at the issue date of the bond.
The third type of bond does not make periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the purchase price (principal) plus the total interest earned, compounded at the original interest rate. These are known as zero coupon bonds and are sold at a discount from their face amount. These are commonly used in capital guaranteed structured products such as “Trackers”.
Maturity A bond’s maturity refers to the specific future date on which the investor’s principal will be repaid. Generally, bond terms range from one year to 30 years. Term ranges are often categorized as follows:
- Short-term: maturities of up to 5 years
- Medium-term: maturities of 5 - 12 years
- Long-term: maturities greater than 12 years
The choice of term will depend on when an investor wants the principal repaid and on risk tolerance. Short-term bonds, which generally offer lower returns, are considered comparatively stable and safe because the principal will be repaid sooner. Conversely, long-term bonds provide greater overall returns to compensate investors for greater price fluctuations and other market risks.
Redemption FeaturesWhile the maturity date indicates how long a bond will be outstanding, some bonds are structured in such a way so that an issuer or investor can substantially change the maturity date.
Convertible bondsSome corporate bonds are known as convertible bonds. These contain an option to convert the bond into common stock instead of receiving a cash payment. Convertible bonds contain provisions on how and when the option to convert can be exercised. Convertibles offer a lower coupon rate because they have the stability of a bond while offering the potential upside of a stock.
YieldA bond's yield is the return earned on the bond, based on the price paid and the interest payment received. There are two types of bond yields: current yield and yield to maturity.
Current yield is the annual return on the amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought a €1,000 bond at par and the annual interest payment is €80, the current yield is 8% (€80 / €1,000). If you bought the same bond for €900 and the annual interest payment is €80, the current yield is 8.89% (€80 / €900). Current yield does not take into account the fact that, if you held the bond to maturity, you would receive €1,000 even though you only paid €900.
Yield to maturity is the total return you will receive by holding the bond until it matures. This figure is common to all bonds and enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity plus any gain or loss of principal.
The Link between Price and Yield 
The inverse also holds true: when interest rates rise, prices of existing bonds fall to bring the yield of those bonds into line with higher-interest bearing new issues. Take, for example, a bond issued with an eight percent coupon. If during the term of that bond interest rates rise to nine percent, it is expected that the price of this bond will fall until its yield to maturity equals nine percent.
When interest rates fall, prices of existing bonds rise until the yield to maturity of these bonds matches the lower interest rate on new issues.
The Link between Interest Rates and MaturityChanges in interest rates do not affect all bonds equally. Generally, the longer a bond's term, the more its price may be affected by interest rate fluctuations. Investors, generally, will expect to be compensated for taking that extra risk. This relationship can be best demonstrated by drawing a line between the yields available on similar bonds of different maturities, from shortest to longest. Such a line is called a yield curve.
A yield curve could be drawn for any bond market. For example it is commonly drawn for the U.S. Treasury market, which offers bonds of comparable credit quality for many different terms.
A normal yield curve would show a fairly steep rise in yields between short- and intermediate-term issues and a less pronounced rise between intermediate- and long-term issues. This curve shape is considered normal because, usually, the longer an investment is at risk, the more that investment should earn.
The yield curve is said to be steep, if the yields on short-term bonds are relatively low when compared to long-term issues. This means you can obtain significantly increased bond income (yield) by buying a longer maturity than you can with a shorter maturity bond. On the other hand, the yield curve is flat if the difference between short- and long-term rates is relatively small. This means that there is little reward for owning longer-dated maturities.
When yields on short-term issues are higher than those on longer-term issues, the yield curve is inverted. This suggests that investors expect interest rates to decline in the future and/or short term rates are unusually high for some reason, e.g., a credit crunch. An inverted yield curve is often indicative of a pending recession as the market is suggesting that short term interest rates are too high for the prevailing economic conditions.
Default Default is the failure of a bond issuer to repay the principal or interest when it falls due.
Bondholders are creditors of an issuer, and therefore, have priority to assets before equity holders (e.g., stockholders) when receiving a payout from the liquidation or restructuring of an issuer. When default occurs due to bankruptcy, the type of bond you hold will determine your status.
Credit Quality The array of credit quality choices available in the bond market ranges from the highest credit quality sovereign bonds, which are backed by the full faith and credit of the issuing government, to bonds that are below and considered speculative, such as bond issues by a start-up company or a company in danger of bankruptcy. Since a bond may not reach maturity for years to come, credit quality is an important consideration when evaluating investment in a bond. When a bond is issued, the issuer is usually responsible for providing details as to its financial soundness and creditworthiness.
Credit Ratings Major rating agencies include Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s). Bonds rated in the BBB/Baa category or higher are considered investment-grade; bonds with lower ratings are considered high yield, or speculative.
The rating agencies make their ratings available to the public through their ratings information desks and online through their respective websites.Rating agencies continuously monitor issuers and may change their ratings of such issuer’s bonds based on changing credit factors. Usually, rating agencies will signal they are considering a rating change by placing the bond on CreditWatch (S&P), Under Review (Moody’s) or on Rating Watch (Fitch Ratings).
Not all credit rating agency evaluations result in the same credit rating. You should bear in mind that these ratings are opinions only, and you should understand the context and rationale for each opinion. Investors should not rely solely on credit ratings as a measure of credit risk but, instead, use a multitude of resources to assist in their evaluation and decision making. Additional sources of information include recent independent news reports, formal issuer press releases, research reports and company financial statements.
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