Bonds

Bonds are 'traditional' financial products to invest in, similar to stocks, but they are generally less risky. The level of return and risk associated with bonds varies depending on the type, the maturity, and the issuer – that is, the entity that created them to raise funds. Therefore, it's important to understand what bonds are and how they work before choosing to invest.

What is a bond?

When you buy a bond, you're essentially making a loan to the issuer. The issuer, which can be a company or a government, commits to repaying you a sum, known as the redemption value, which is usually equal to the bond's face value. This repayment takes place when the bond matures. Often, the issuer also agrees to pay you periodic interest, known as a coupon.

If the issuer is a government, the bond is called a government security. In Italy, government securities include Treasury Bills (BOTs) and Treasury Bonds (BTPs) .

Different types of bonds

Fixed-rate, variable-rate, short, medium, and long-term, senior, subordinated, structured – these are all terms you might come across when looking for a bond to invest in. Bonds differ based on various features. Let's look into them.

Based on the type of coupon, bonds may be:

• fixed-rate: pay a fixed coupon, meaning a predetermined interest;
• variable-rate: pay a variable coupon, linked to market interest rates. All else being equal, variable-rate bonds are less risky than fixed-rate bonds;
• inflation-linked: the coupon, and often the redemption value, increases with inflation. These protect against inflation and, on average, carry a risk level between fixed- and variable-rate bonds;
• zero-coupon: pay no interest, like BOTs. The return comes only from the difference between the purchase price and the selling price or redemption value.

Based on maturity, bonds are usually classified as:

• short-term: maturing in less than one/two years;
• medium-term: maturing in more than one/two years but less than five/ten years;
• long-term: maturing in five/ten years or more.

Bonds can also be categorized by 'seniority' which indicates the priority in receiving proceeds from the liquidation of assets in case the issuer goes bankrupt. Proceeds are first allocated to holders of ordinary bonds (also called senior bonds) and other senior creditors. Subordinated or junior bondholders are paid only after these claims are satisfied. All else being equal, subordinated bonds are riskier than senior ones because the recovered value from asset liquidation might not cover all debts.

There are also structured bonds, which are complex instruments that include a derivative contract. Their return depends on the performance of one or more variables, such as stock indices, shares, investment funds, exchange rates, or raw materials. Due to their complexity, you should fully understand how structured bonds work and the risks involved before investing.

Bond yields

The yield to maturity of a bond – the gain you obtain if you hold it until maturity – comes from the periodic coupon and the discount at issuance/trade premium - (the difference between the bond's redemption value/face value and the subscription/trade price).

In the case of zero-coupon bonds like BOTs, the yield comes only from the discount or premium. For example, if you buy a BOT for €97 with a face value of €100, the discount is €3. For BTPs, the yield includes both the coupon paid every six months and any discount or premium.

Just as you can buy a bond on the secondary market past the time of issue, so too can you sell it there before maturity. In this case, your return depends on the coupons collected while you held the bond and the difference between the sale price and your purchase price.

Bond risks

As with any investment, buying bonds involves risks in exchange for the expected return.

Bond yields may rise (and prices fall) for different reasons. The two main ones are:

• a general increase in market interest rates (interest rate risk);
• a worsening financial situation of the issuer, possibly leading to failure to pay coupons and to redeem the bond at maturity (credit risk).

Interest rate risk is higher for long-term bonds (BTPs can go up to 50 years) and affects fixed-rate bonds the most. Because higher risk should yield higher return, longer-maturity bonds from the same issuer (like the Italian government) usually offer higher yields.

Another risk is currency risk, when the bond is denominated in a currency different from the one you earn and spend in (e.g., USD instead of EUR). When the bond is sold or redeemed, the amount received in euros may be less than what you invested – even if the bond's price in dollars hasn't dropped.

How to reduce risks

Concentrating investments in bonds from a single issuer is risky – your return depends entirely on that issuer's financial health.

It's also risky to invest in bonds with similar maturities and the same coupon type (fixed or variable). In particular, long-term fixed-rate bonds may experience significant price swings if inflation expectations or long-term interest rates rise.

You can reduce risk through diversification: invest in fixed- and variable-rate bonds, with varying maturities, and issued by companies, financial institutions, governments, and supranational bodies operating in different sectors and countries.

People often underestimate the close link between return and risk. Higher yields typically indicate lower issuer reliability—investors demand greater compensation for higher risk. So be cautious with bonds offering unusually attractive returns.

Rating and spread

Two commonly used terms in bond investing are rating and spread.

Rating is a score assigned by specialized agencies (rating agencies) that evaluate the creditworthiness of bond issuers. A higher rating means the issuer is more financially solid and less likely to default, making the bond less risky.

Spread is the difference between the yields of two bonds. In Italy, it often refers to the difference between the yield on a 10-year Italian government bond and that of the equivalent German bond. A higher spread indicates higher perceived risk and a higher return required by investors.