In this post we will focus on bonds, an asset class that not many investors are familiar with as it does not get the same media attention as stocks. However, bonds feature in almost every diversified investment portfolio, especially those of retirees and conservative investors. In a previous post we discussed how bonds fit in an overall investment portfolio, so in this post we will explain how bonds work and discuss factors to consider when investing in bonds.
A bond is a tradable debt instrument issued by an entity as a means of borrowing, where lenders that provide the financing receive bonds that they can hold until the maturity date or sell in the market. The holder of a bond is entitled to receive interest payments at specified intervals and to repayment of principal on the maturity date. Bonds issued by governments are called treasury bonds, while those issued by companies are referred to as corporate bonds. Furthermore, a bond is created via a legal agreement, called a trust deed or indenture, executed between the borrower and a trustee who acts on behalf of lenders. The trustee appoints a registrar and paying agent who is responsible for maintaining a list of lenders, referred to as bondholders, and for making interest and principal repayments on behalf of the borrower. Within this structure, investors are free to buy and sell bonds without having to become a party to the legal agreements.
Moreover, certain conventions have been established to enable trading of bonds in financial markets. The principal amount of a bond is known as the face value, and this represents the amount that will be repaid on the maturity date. Bonds are issued with face values in multiples of 1,000 with each issue specifying a minimum transaction size. Meanwhile, interest paid on bonds is referred to as the coupon. Coupons have standard payment intervals, such as quarterly or semi-annually, and the coupon rate can be either fixed or variable, with the latter changing in line with a set benchmark rate. Bonds also have set maturity dates, with the period remaining to the maturity date referred to as the tenor. Most bonds in issue repay 100% of principal on the maturity date but there are also amortizing bonds that repay principal over the life of the bond.
In accordance with market convention, bond prices are quoted per $100 of face value. New bonds are usually issued at a price of $100 which means the amount the investor pays for a bond is equal to the principal amount or face value. The bondholder receives the coupon each year and gets back $100 on maturity, resulting in an annual return that is equal to the coupon rate. This annual return on a bond is referred to as the yield. Meanwhile, there are different types of yield with the most common being yield to maturity, which represents the average annual return on a bond bought at a particular price and held to maturity. In the bond market, variable rate bonds tend to trade at a price close to the face value as the coupon rate resets as interest rates change, giving the bondholder a yield close to the market interest rate. However, for those bonds that pay coupon at a fixed rate, when interest rates change there may be a difference between the interest rate in the market and the fixed coupon rate on the bond. Given rates of return desired by investors are based on interest rates in the market, a change in interest rates after a fixed rate bond is issued would result in investors buying or selling that bond at a price that is different from the face value.
When interest rates rise after a fixed rate bond is issued, investors will require an annual return or yield that is higher than the coupon rate. Since the coupon rate is fixed, investors would only buy the bond at a price below the face value amount, resulting in the coupon plus the difference between the face value and the discounted price providing the desired higher return. Therefore, when the price is below $100 the yield will be higher than the coupon as the investor will receive the coupon plus the amount by which the principal repayment exceeds the price paid. Conversely, a price above $100 means the yield will be below the coupon. When the price is equal to the face value of $100, this is referred to as par, while a price below $100 is said to be at a discount and a price above $100 is at a premium. This indicates that there is an inverse relationship between the bond price and the bond yield where a higher price means a lower yield and vice versa. Therefore, when interest rates rise, bond prices will fall, while a fall in interest rates will lead to higher bond prices. You can use an online bond calculator to check how changes in yield impacts the bond price and vice versa.
You would have noted from the explanation above that there are two components of the return from investing in bonds. One is the coupon payments collected from holding bonds, the other is the capital gain realized if a bond is sold at a different price from which it was bought. Generally, bond investors tend to buy bonds to collect the regular coupon and the principal repayment at maturity. Long-term investors usually avoid selling bonds when interest rates fall, and the price goes up, as this would mean having to reinvest in a new bond at a lower coupon rate which may not be desirable.
Meanwhile, there are risks associated with investing in bonds that investors should pay attention to, including the following:
- Credit risk. A bond is a form of debt so the most important risk the bondholder faces is the possibility the borrower may not be able to pay interest and principal on the bond. This is referred to as default or credit risk and is measured by credit ratings. Credit ratings are assigned by credit rating agencies with Standard and Poor’s, Moody’s and Fitch being the major international rating agencies, while Caricris rates local and regional entities. Credit ratings are expressed using the categories AAA to C where an AAA rating is the best and a C rating the worst. The rating scale can be divided into two broad groups, investment grade rated bonds which, under the S&P rating scale, include AAA to BBB-, and non-investment grade or speculative grade bonds, which include BB+ to C rated entities. Investment grade bonds are considered safe with a low risk of default, while speculative grade bonds, also referred to as junk bonds, are viewed as lower quality and higher risk.
- Liquidity risk. This refers to the risk that an investment cannot be sold in a reasonable period of time without material loss of value. One can gauge the liquidity of a bond by looking at trading volume as well as the differential between the bid price and the offer price. While liquidity risk is a consideration in the trading of bonds, it is unlikely to be a concern where a bond investment is being held to maturity.
- Interest rate risk. Also known as market risk, this refers to the fact that a change in interest rates can lead to a change in bond prices. The change can be favourable, where bond prices rise when interest rates fall, or unfavourable when the opposite happens. Generally, bonds with long tenors experience a greater change in price for a given change in interest rates when compared to bonds with a short period to maturity. This risk is applicable to investors who expect to sell their bonds prior to the maturity date. However, it should be noted that changes in interest rates can also affect investors who hold bonds to maturity by impacting the rate at which bond maturity proceeds are reinvested.
- Prepayment risk. This is where a borrower repays a bond before the maturity date. Prepayment represents a risk to the bondholder who may not find a comparable yielding bond to reinvest the proceeds as borrowers tend to prepay bonds when interest rates have fallen so they can then refinance at a lower rate. While most bonds include a penalty for prepayment, there are bonds that allow the issuer to make early repayments without penalty, so you should check for any prepayment provision when buying a bond.
Generally, investors can buy new bonds being issued in the primary market from the arranger, or previously issued bonds from an existing holder in the secondary market. In Trinidad & Tobago, however, the secondary bond market is not very active so most of the opportunities to buy bonds arise when a new issue is being sold. For USD bonds in the US Corporate bond market or the Eurobond market, access to new issues is limited so, usually, these bonds can only be bought in the secondary market where they are actively traded. Given bond trades are conducted over the counter, meaning between two brokers in a negotiated transaction, you will need to use a fixed income broker to obtain access to bonds.
Meanwhile, when you are selecting bonds for your portfolio, the following are some of the factors you should pay attention to:
- Credit risk. If your risk tolerance is low to moderate, then you should consider sticking to investment grade rated bonds which, while offering lower returns, have minimal risk of loss of principal. Should you decide to buy bonds with a speculative rating, ensure you are comfortable with the level of risk and that the extra return obtained represents adequate compensation for the additional risk taken. Also, where a bond is not rated, you will have to do your own assessment of credit risk to ensure the investment is acceptable to you, both in terms of your risk tolerance and the return offered.
- Yield. Bond price and bond yield are related as the price is set based on the yield desired by the seller. There are two key factors that impact bond yields in a given interest rate environment, the credit risk of the borrower and the term to maturity of the bond. Yields will generally be higher for lower rated borrowers and for bonds with longer maturities. When you are buying a bond, you should ensure the yield offered is comparable to other bonds with similar credit risk and tenor. For a given entity or credit rating there are usually different yields for different periods of time to maturity. In financial markets this yield/tenor relationship is referred to as the yield curve. For example, the yield curve for Government of Trinidad & Tobago TT Dollar bonds as of 31 July 2023 was as follows:
While the reasonableness of yields on treasury bonds can be easily determined using the sovereign yield curve, yields on corporate bonds are more difficult to assess. This is because they involve consideration of both the company’s credit rating relative to that of the sovereign, as well as the level of compensation for the extra risk taken. The difference in yields between the sovereign and corporate issuers is referred to as the credit spread and varies depending on market conditions. As a result, knowledge of the market is important when assessing the appropriate yield for a particular corporate bond.
- Term to maturity. While there may be a secondary market for bonds, when investing in bonds you should ensure the length of time to the maturity date fits with your investment horizon as you may have to hold the bond to maturity if you are unable to sell it in the secondary market.
- Interest rate outlook. Given the inverse relationship between bond prices and yield, the best time to buy bonds is when interest rates are at or close to their peak. In such a scenario, coupons are likely to be at their highest and any subsequent fall in interest rates will lead to a higher value for the bonds. In cases where interest rates are expected to rise and you must buy bonds, stick to short tenor bonds that mature when interest rates are expected to peak, so you would be able to reinvest at a higher rate.
- Debt seniority ranking. There are different levels of seniority in corporate debt structure with secured debt ranking first in priority of payment, and therefore being the safest, followed by unsecured and then subordinated, which is the lowest ranked debt with the highest risk. You should ensure that you are comfortable with where a bond ranks in the company’s capital structure before you invest. Subordinated debt, as well as unsecured bonds issued by entities with significant secured debt, would be considered high risk and should be avoided.
In conclusion, it should be noted that since bonds trade over the counter and there is a degree of complexity involved in assessing bond investments, it is advisable to liaise with a broker when adding bonds to your portfolio. The role of the broker would be to find available bonds and to provide bond market information to enable you to make an informed decision on which bonds are suitable for your portfolio. Knowing how bonds and the bond market work, as well as understanding the factors to consider when investing in bonds, would help you to ask the right questions and make informed decisions on bond investments.
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