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Bonds, a gentle introduction

Digging into an IOU-based investment strategy, where investors lend money to companies and governments and make money through interest payments.

Imagine you are the lucky owner of the famous XYZ company. Your business is going pretty well, so you dedice to expand it by buying a $3,000,000 machinery. If XYZ company is public, which means it has shares freely traded on a stock exchange, you have two options to finance your idea:

  1. issue more shares – you collect money from new shareholders who buy your new shares;
  2. borrow the money you need – you go asking someone (typically a bank) for those $3,000,000.

Either way you would end up with +$3,000,000 in your company's asset.

For wathever reason you decide to go with the option #2, but unfortunately you've been unable to find a bank who is willing to give you that much. Not all hopes are gone, though: you don't need to borrow all that money from a single entity: what about acquiring, say, $10,000 from 300 investors? You can do that publicly through bonds, issued by your company.

Anatomy of a bond

Bonds are a form of agreement between your company and the investor, who lends you a part of the money you're looking for for a limited amount of time. Of course she would not give away her gold for nothing: your company must pay the investor something extra for the privilege of using her money, in the form of interest.

Decades ago bonds were a piece of paper as displayed in the picture below, today they are a record in a database. Whether physical or logical, bonds are made of four main components:

  • price – bonds, like stocks, are publicly traded as we will see later, so they have a cost for those who want to buy them. The price paid by the investor corresponds to the amount of money lent to the bond issuer;

  • face value – this is also known as par value (don't ask me why) and it's how much the investor will get once the agreement is over. Bonds usually have a face/par value of $1000 each;

  • coupon – how much interest the investor will receive, expressed as a percentage of the face value. The name comes from the past, when physical bonds had a real coupon to tear off for redeeming the interest. Bonds may pay interest every six months, monthly, quarterly or annually. A bond with an annual coupon of 10% and a face value of $1000 pays $100 of interest a year;

  • maturity – it's the expiration date. On that date investors will cash in the face value. The maturity date can range from 1 day to infinite years (the so-called perpetual bonds) making bonds more or less lucrative. A bond that matures in 20 years is much less predictable than a bond that matures in 1 month, and thus riskier. Therefore, in general, the longer the time to maturity, the higher the coupon value: investors must be rewarded for the risk they're taking.

We will see some examples with real numbers in a minute.

Differences between issuing bonds and stocks

Is it better for a company to issue stocks or bonds when it's time to raise money? There are several factors to take into account.

  • Level of commitment granted – Once investors buy a stock they own a slice of the company. They have a right to demand explanations and justifications for the company's decisions. Issuing bonds on the other hand has no effect on the level of ownership; investors only own the right to cash in interest on the money they are lending;

  • stock dilution effect – Issuing more stocks splits the pie among a larger number of owners. The operation changes fragile parameters like the earnings per share ratio (EPS), something investors keep looking when evaluating a company's health. Issuing bonds does not change a thing instead: firms can issue them whenever they need money without altering their precious prospectuses. Moreover, bonds have a limited life (maturity): borrowing money only when you need it is handy. On the other hand redeeming or purchasing stocks back is not a walk in the park, and it does not happen so often for this very reason;

  • taxation – With bonds, the company pays investors an interest which is tax-deductible as an expense, unlike stock dividends;

  • cash flow – A company must pay interest payments on time to bondholders. This differs from dividends, which are paid only when declared. A company can also stop paying dividends or altering the dividend yield according to its needs;

  • bonds look lame – Bonds, unlike stocks, increase the amount of debt a company shows on its financial books. Investors often look at debt as a factor that makes a company attractive or unattractive.

There are bonds and bonds

Besides companies, also states and countries can issue bonds, who need to expand or upgrade their physical properties like streets, schools, bridges and such. In fact there are two main branches of bonds:

  • Corporate bonds – bonds issued by companies;
  • Municipal bonds – bonds issued by states, countries, municipalities.

They are structured in the same fashion. Yet, municipal bonds are known to feature lower coupon rates. The average yield on municipal bonds over the past 10 years has been just over 4%, whereas corporate bonds have averaged between 5 and 7%. In addition, if you own municipal bonds you won't pay taxes on the interest you receive (at least in the U.S.), unlike for corporate bonds.

A physical bond from the state of Luisiana.
1. A physical, municipal bond from the state of Luisiana, dating back to 1875. Notice the detachable coupons on the right.

Other interesting bonds formulas

Minor tweaks to the three ingredients above generate many flavors of bonds. The coupon value, for example, can be fixed or floating. If fixed, every n months you get the same interest rate as defined in the coupon value. If floating, the rate changes according to external measures, for example the market's interest rates, as we will see later.

If the coupon value is zero you have the zero-coupon bonds: bonds that do not pay interest at all. Those bonds usually have a lower price if compared to the face value and have a longer maturity date. They are useful for those who are planning long-range goals: an investor can put up a small amount of money that can grow over many years.

Finally, convertible bonds give the investors the ability to convert them into stocks of the issuing company. Only corporate bonds can be convertible, of course. They usually feature a lower coupon value, because convertible bond can be changed into stock and thus benefit from a rise in the price of the underlying stock.

Handling bonds

Bonds, like stocks, are a publicly traded security, so they follow the same rules I've described in my previous article on how to buy and sell stocks. This means that they are traded in their bond market, following the supply/demand rule, having bid and ask prices, market makers, different types of orders and so on, as if you were buying stocks. This fact adds an important bit of information: bonds have a price that changes over time, following the sympathy of their market.

This can be confusing at first: you have the face value – how much you will get back at maturity and the price value – how much you are paying for the bond. What does that mean? When bonds are issued for the first time they have a face value equal to their price. Then, once they have entered the market, the price changes according to the supply and demand rules out there. When the price is higher than the face value investors say that it's trading at a premium. When the price is lower they say that it's trading at a discount.

When you buy a bond, you pay the bond price; at the maturity date, you will get back the face value. It doesn't matter how much you paid for it. Whatever the face value is, that's what you get. However nobody forces you to keep the bond until the maturity date. You can sell it whenever you want on the bond market. In such case you would get a far different amount: the current bond price.

The day-to-day fluctuations in the bond's price may not be as important to you if you plan to hold a bond to maturity. The price may change, but you will be paid the stated interest rate, as well as the face value of the bond, upon maturity. On the other hand, instead of holding the bond to maturity, you might be able to sell the bond and reinvest the resulting cash into another bond that pays a higher coupon rate.

Yield: another way of measuring bonds

Suppose you have just bought a bond: you could simply keep collecting interest on the face value, then at the maturity date you cash in the face value itself and call it a day. It works, but you are not taking into account how much you paid for it: in other words, your initial investment. The yield or yield rate is a tool to better track your bond's performance.

Several types of bond yield formulas exist, too many for this gentle introduction. For now, think of the yield rate as the amount of return you realize on a bond: given what you've paid for it, how much you will get in return?

For the following example I'm going to use the simplest form of yield computation, called current yield. This type of yield takes into account the price and the annual return only:

§ "current yield" = "annual interest paid" / "bond price" * 100 §

Imagine you have just spotted an interesting bond that generates $50 per year. Let's forget about the face value and focus on the price: if today it costs $1000, then its yield amounts to 5% per year, because § {50$} / {1000$} * 100 = 5%§. One day passes and for some reason the bond's price shifts down to $950. Since the amount of cash it generates does not change, the new yields now amounts to 5.26% per year, because § {50$} / {950$} * 100 ~= 5.26%§. This is kind of intuitive: the less you have to invest to obtain those $50 every year, the higher the yield is.

Notice how the yield is inversely proportional to the price. When the price goes down, the yield goes up and vice versa.

My previous yield formula was a naive one: there are many more intricated ways of computing bond yields. They are useful when you want to keep track of all the variables that drive a change in bonds yield, like for example the market interest rate as we will see in a minute. I will delve into those advanced formulas in future chapters.

What drives bond prices?

Bonds are fun because, more than stocks, are somehow tied to the underlying economy. I'm talking about market interest rate – the cost of borrowing money: this is the main factor that generates changes in bond prices.

Understanding the forces behind the market interest rates is definitely outside the scope of this article. For now let's grasp a fundamental principle: market interest rates and bond prices move in opposite directions. When market interest rates rise, prices of bonds fall. This is known as interest rate risk. Why it happens?

Bond prices and interest rates.
2. The inverse relationship between bond prices and market interest rates.

First of all, it is useful to know that bond issuers always set the coupon rate to the current market interest rate, when they release a new bond. While the bond's coupon rate will not change, the market interest rate will be constantly changing due to global events.

Given that premise, imagine that today the market interest rate is 3%. In addition a new bond XYZ bond is issued today, with an annual coupon of 3% (of course). You decide to buy it. The day after some magic happens and the market interest rate drops to 2%. Your XYZ bond does not change and keeps paying 3%, unlike new bonds issued, that will feature annual coupons of 2%. That's cool! Other investors who buy bonds now would get a disappointing 2%, while your bond keeps paying 3%.

The bond market realizes that pretty quickly: investors start looking for bonds issued prior the % change. The natural supply and demand rule eventually pushes up the price of bonds with higher coupon rate like your XYZ.

What about the yield? Given what we know about it, the yield goes down accordingly, since the price has gone up: the yield is inversely proportional to the bond price. What follows is a kinda nerdy diagram of the whole process. I'll let you figure out how the whole thing works when market interest rates goes up instead.

market interest rates(-) ⇒ existing bond prices(+) ⇒ existing bond yields(-)

Mind the low-interest rate environment

When you are in a low-interest rate environment, there's one event that might happen: a rise in the market interest rates! Old bond prices will drop accordingly as we all know, however some of them will suffer more:

  • Bonds with longer maturity – Some of their payments are very distant points in the future (think of a bond that matures in 50 years): why an investor would want to keep a yield of 2% for decades when new bonds with shorter maturity will output much more? So when interest rates rise, those very distant cash flows of long-term bonds are discounted in value significantly and the price falls abruptly;

  • Bonds with lower coupon rates – the key concept here is called Yield To Maturity (YTM). This is another yield formula, used to compute the yield a bond has when held until its maturity date. What happens is that as market interest rates rise and fall, the price of current bonds adjusts so that the YTM matches the current YTM of new similar bonds. Think of two bonds that have 5 years left on them. Bond #1 pays 4%, bond #2 pays 2%. When the market interest rates rise and new bonds come in with a higher yield (say 5%), the price of those two bonds will adjust down until their effective yield become %5. I don't want to be too mathy here: simply put, the 2% bond price needs to fall more than the 4% bond in order to match the new yield.

We can now expand the previous nerdy diagram with new information on low-interest rate risk:

market interest rates(-) ⇒ existing bond prices(+) ⇒ existing bond yields(-) ⇒ interest rate risk(+)

Bond rating and risk

Sometimes things go wrong and the company you lent money to goes bankrupt overnight. What happens to your bond, then? Bond rating might help you prevent such scenarios. A bond rating is a valuation given to a bond that indicates its quality, or the creditworthiness of a bond issuer. The higher the rating the safer the investment. They are also useful to make it faster for investors to evaluate risk.

The valuation usually goes from "AAA" (the best) to "D" (the worst) and it's performed by rating agencies. Their job is to monitor the issuer's financial books, as its ability to repay previous interest on time and in full. You will find three main rating agencies in the U.S.: Moody's Investors Service, Standard & Poor's and Fitch Ratings. The following table shows a subset of the most common values:

Moody's Standard & Poor's/Fitch Grade Risk
Aaa AAA Investment Low
Aa AA Investment Low
A A Investment Medium
Baa BBB Investment Medium
Ba, B BB, B Junk High
Caa, Ca CCC, CC Junk High
C D Junk High/Default

The grade column splits bonds into two main branches: investment when the bond carries relatively low risk, junk when you are dealing with precarious stuff, or even garbage. A company whose bonds are in the D category might face default: the failure to pay interest (or face value) when due.

Generally speaking, the higher the bond's rating, the lower the yield you are likely to receive. Low pain implies low gain. However ratings change, so it's important to frequently review the valuation over the life of a bond. What if a company doesn't have its bonds rated? It is up to the investor to understand the firm's repayment ability.

Where do I find bonds data?

Unlike stocks, it's hard to find bond information on the net. This is likely due to the fact that there is not a lot of demand from private investors. With bonds your investments won't skyrocket in value over the long run and people are less excited about that. You have two options here:

  • browse your brokerage account research tools. This is the best way to fetch for information;
  • use public tools like Yahoo Bond Center. It works fine, but lacks of some useful details.

Sources

Khan Academy - Introduction to bonds (link)
Khan Academy - Bonds vs. stocks (link)
Khan Academy - Bond Prices and Interest Rates (link)
Investopedia - Municipal Bond (link)
Investopedia - Where can I get bond market quotes? (link)
Investopedia - If I buy a $1,000 bond with a coupon of 10% and [...] (link)
Investopedia - Why Companies Issue Bonds (link)
Investopedia - Bond Ratings (link)
SEC - What Are Corporate Bonds? (link)
SEC - Bonds, Selling Before Maturity (link)
SEC - Interest rate risk (link)
SEC - Zero Coupon Bonds (link)
Thismatter.com - Bond Pricing (link)
Thismatter.com - Bond Yields (link)
The Finance Base - Bond Par Value vs. Market Price (link)
Neighborly - Not Every Bond is a Municipal Bond [...] (link)
The Motley Fool - 5 Bond Market Facts You Need to Know (link)
Chron - Advantages & Disadvantages of Issuing Stock or Long-Term Debt (link)
AAII Journal - How Interest Rate Changes Affect the Price of Bonds (link)
Money.stackexchange - Why bonds with lower coupon rates have higher interest rate risk? (link)