Bond Basics - The Woo Group RBC Wealth Management Hong Kong USA
Often considered to be one of the most conservative of all investments, bonds actually provide benefits to both conservative and more aggressive investors alike. The variety of bonds available provides an array of options to meet many investment goals, from earning regular income to achieving capital appreciation much like stocks. To understand these benefits, it is important to understand how bonds work. This fact sheet explains the fundamentals of bonds, addressing: how bonds are structured and priced; what factors affect prices; how to measure return; types of bonds; bond risks; and bond taxation. By learning about these bond basics, you’ll be on your way to understanding how bonds can contribute to your investment goals.
In the financial world, there are fundamentally two types of security investments: debt and equity. Issuing debt (bonds) is an important way for different types of issuers to raise money to fund projects or build capital. The most common bond issuers include: federal governments, federal agencies, municipalities, and corporations. While all of these entities can issue debt (bonds), only a corporation can issue equity (stock).
One of the key ways in which bonds differ from stock relates to the issuer’s obligation to the investor. When an investor buys stock in a corporation, that investor becomes a partial owner. The stock offers the possibility of capital appreciation and dividend payments to the stockholder, with no guarantee that either of these will occur.
A bond, on the other hand, makes a promise of return to the bondholder. The issuer agrees to pay the bondholder a fixed interest payment on a regular basis until the bond’s maturity, at which point the issuer will pay the original face value of the bond. A bond certificate, in essence, is simply a promissory note or “IOU”, which legally binds the issuer to repay the amount paid per the IOU and describes the terms of the loan. As a creditor of the issuer, the bondholder has a senior claim on the liquidation of assets over stockholders if the issuer were to file bankruptcy.
Bonds, in the most generic sense, are issued with three essential components.
Maturity — Maturity indicates the life of the bond. Most bonds have maturities ranging from 3 months to 30 years.
Par Value — Par value, also called face value, is the amount the bondholder will be repaid when the bond reaches maturity. For instance, if you purchase a $1,000 par value bond, you will receive $1,000 at maturity.
Coupon Rate — Coupon rate (also referred to as interest rate) is the percentage of par value that will be paid to bondholders on a regular basis. For example, if you purchase a $1,000 par value bond with a 10% coupon rate you will receive $100 interest each year.
Characterized by fixed interest payments and a return of principal at maturity, bonds are commonly referred to as fixed income securities.
Why Buy Bonds?
Investors purchase bonds to take advantage of their many benefits compared to alternative investments.
Safety/Capital Preservation — Because the bond issuer must pay back the bond’s face value at maturity, an investor’s original principal is preserved, unlike stock where the investor can lose the original investment value. The degree of safety varies with bonds of different types and ratings.
Fixed Return — Investors receive fixed, regular interest payments which provide an element of predictability versus common stocks where the returns are less certain.
Current Income — For those wanting a regular cash income, bonds provide regular interest payments at set times.
Reduce Portfolio Risk — Due to their more certain nature compared to equities and their divergent behavior in tumultuous markets, bonds are a great way to reduce the risk in an investment portfolio.
Capital Appreciation — Many investors benefit from trading bonds in the secondary market to take advantage of price increases, much the same way as they would trade stocks.
How is the Bond’s Coupon Rate Determined?
A bond’s coupon rate is determined when the issuer first creates the bond offering and sells it in the new issue market, commonly called the primary market. A number of factors influence the level of a bond’s coupon rate. The main factor is the level of interest rates prevalent in the economy, in general, and more specifically interest rates prevailing for bonds of the same credit quality and structure. For instance, investors will demand a higher coupon for a corporate bond rated single A relative to a U.S government bond to compensate for the lower credit quality of the corporate bond. Another factor influencing the coupon rate includes the length of the bond’s maturity with longer-term bonds normally posting higher coup
How is the Bond’s Price Determined?
After a bond is first issued in the primary market, it becomes part of the secondary market — composed of buyers and sellers of outstanding securities. The bond’s price will fluctuate in the secondary market above or below the original issue price to reflect changing market conditions. However, purchasers of the original issue don’t need to fret about price movements of their bonds because such fluctuations won’t affect the payback of the bondholder’s original principal amount at maturity, the par value. This return of principal, regardless of price volatility, is one of the key benefits of holding bonds. Many investors, however, have learned to capitalize on bond price movements by trading bonds and realizing gains on price appreciation, as they might with common stock. To do this, investors need to understand the combination of factors which drive bond price movements; the main determinants are interest rate movements; credit quality; length to maturity; call features; and supply and demand factors.
Interest Rate Level
The most important cause of bond price fluctuations is the changing level of interest rates. As illustrated below, when interest rates in the market rise, a bond’s price will fall. Conversely, if interest rates fall, a bond’s price will rise. For example, suppose that you purchase a 3% coupon bond of ABC Company at its primary issue price, the par value of $1,000. Assume that two years from now the bond is trading in the secondary issue market. At this point, market interest rates have fallen and new bonds similar to yours are being issued at a par price of $1,000, but are paying only a 2% coupon rate consistent with market conditions. Understandably, other buyers in the market would be willing to pay a premium, more than $1,000, for your bond that has the higher 3% coupon rate. Therefore this bond’s price will increase to reflect prevailing rates; this bond trades at a premium price. If you sold your premium bond, you would have a gain on your original purchase.
Consider the opposite case. Two years from now, interest rates have risen and a new bond selling for $1,000 is paying a 4% coupon rate. It would be impossible to sell your bond for $1,000 if it is only paying a 3% coupon rate when new bonds are offering a higher rate of interest. In order to sell your bond, you will have to offer it at a discount to entice a buyer to buy your bond. If you sold your discount bond, you would register a loss from your original purchase price of par value.
Changes in an issuer’s credit quality will also affect the price of its bonds. This factor is most common with non-U.S. government issuers such as corporate and municipal issuers. An issuer’s credit quality is evaluated according to its ability to make timely principal and interest payments to bondholders. Bonds are evaluated for credit risk based on the financial performance of the issuer, both past and present. The major rating agencies for bonds are Standard & Poor’s and Moody’s Investors Service.