A ‘bond’ is an instrument of the fixed income variety. It is representative of a loan from an investor to a borrower, typically being corporate or governmental. One could interpret a bond as being an I.O.U. between the lender and the borrower. Specifically, one that includes the details of the loan, as well as its payments.
The typical users of bonds are companies, municipalities, states, and sovereign governments to finance projects and operations alike. Those who are the owners of bonds are the debtholders, or the creditors, of the issuer. Details of a bond include the end date when the principal of the loan is due for payment to the bond owner. Most of the time, it includes the terms for variable or fixed interest payments as established by the borrower.
Governments – at all levels – and corporations frequently use bonds as a way for them to borrow money. Governments need money in order to fund roads, schools, and various types of infrastructures. The sudden expense of an impending war may also result in high demand for raising funds.
In a similar fashion, corporations will regularly borrow for the purpose of expanding their business. They also need to buy property and equipment and to undertake profitable projects. Not to mention they need to conduct research, work on development, and hire employees. The common problem that large organizations run into is that they need a lot of money. More than the average bank can provide, even. Bonds provide an effective solution by way of allowing individual investors to take on the role of the lender.
How they work
More often than not, bonds are referred to as fixed-income securities. They are one of three asset classes that individual investors are typically familiar with. The other two asset classes are stocks (equities) and cash equivalents.
A majority of corporate and government bonds are subject to public trading. Others, meanwhile, trade only in an over-the-counter (OTC) manner. Alternatively, the trade is private and occurring between the borrower and lender.
There will come a time when a company or other entity will need to raise money to finance new projects. Moreover, they will need to maintain ongoing operations and/or refinance existing debts. To do this, they may go on to issue bonds directly to investors. The borrower (issuer) issues a bond that includes a few key factors:
- The terms of the loan.
- Interest payments that will eventually be made.
- The maturity date. This is the time at which there is a reimbursement of the loaned funds (bond principal).
The interest payment (i.e. the coupon) is part of the return that bondholders earn. They acquire it in exchange for loaning their funds to the issuer. The interest rate that is responsible for determining the payment is the ‘coupon rate’.
The initial bondholder can sell most bonds to other investors following their issuance. In other words, there is no need for a bond investor to hold a bond throughout the duration of its maturity date. Furthermore, it is also not unorthodox for the borrower to repurchase bonds. Especially not if interest rates are on a decline or if the borrower’s credit is improving. It can even reissue new bonds at a comparatively lower cost.
A majority of bonds share some common characteristics, some of which include:
- Face value: This is the money amount that the bond will be worth upon reaching its maturity. Additionally, it is the reference amount that the bond issuer uses when they are calculating interest payments. Let’s say, for example, an investor purchases a bond at a premium $1,090. Moreover, another investor buys that same bond at a later time when it’s trading at a discount price for $980. By the time the bond matures, both investors will receive the $1,000 face value of the bond.
- The coupon rate: This is the rate of interest that the bond issuer pays on the face value of the bond. It is typically expressed as a percentage. For instance, a 5% coupon rate means that bondholders will receive a 5% x $1000 face value. This equals out to $50 on an annual basis.
- Coupon dates: These are the dates on which the bond issuer will conduct the interest payments. Executing these payments can be during any interval, though the standard is semiannual payments.
- The maturity date: As you may recall, this is the date on which the bond matures. The bond issuer pays the bondholder the face value of the bond at this point.
- The issue price: This is the price at which the bond issuer originally sells the bonds.
A bond has two features that are the principal determinants of a bond’s overall coupon rate. Those are the credit quality and time to maturity. Say that the issuer happens to have a poor credit rating. In this case, the risk of default is much greater and these bonds pay considerably more interest. Moreover, bonds that have a very long maturity date, more often than not, pay a higher interest rate. This higher compensation stems from the bondholder’s heavy exposure to interest rate and inflation risks for an extensive period.
Impact and high-yield bonds during the pandemic
With the pandemic continuing its spread, investors desperately seeking safety are looking to buy bonds. However, interest rates are declining, so traditional bonds will provide them with very low financial returns. Some are starting to look into impact investments as a way to diversify their portfolios.
An ‘impact bond’ is a loan to an organization, typically one that is non-profit. It offers investors a financial return on top of making a direct social or environmental impact for the better. Each bond possesses a different minimum investment, interest rate, and maturity date. A variety of impact bonds will usually generate different types of impact.
It is important that investors need to evaluate the risk before they buy. What’s more, they should allocate only a small portion of their portfolio to impact bonds. There are three main risks pertaining to impact bonds:
- Liquidity risk: The investment is locked-in and is typically for 3 to 10 years
- Duration risk: The interest rate is fixed, so investors will fail to benefit if interest rates increase.
- Default risk: If the organization experiences bankruptcy, then investors could lose some or all of their money
According to Fitch Ratings, in light of the COVID-19 outbreak, almost one-quarter of high-yield corporate bond issues in North America will suffer. Approximately 36% of high-yield corporations “have low rating headroom.” This means that they will probably face substantial rating downgrades. Such issues consist of 50% of those from airlines, 47% from oil and gas, and 44% from restaurants.
Are you someone who wants some balance in your portfolio? If so, then adding a bit of bond exposure along with an asset allocation strategy is not a bad idea. However, there are some who show an interest in selling their stocks to replace them entirely with bonds. If you are one of these people, then you are out of luck. It’s likely that you may wind up switching away from stocks at the worst possible time.