Bonds

What they are

Bonds are instruments that give their holders the right to receive, at the maturity date stated on the instrument, repayment of the amount invested as well as income in the form of interest ('coupon'). The issuer, for whom the bond represents a debt since the proceeds of its sale are used for funding purposes, can be:

  • a State (see 'government bonds') or other government entity;
  • a bank or other type of company (in this case, they are referred to as 'corporate bonds');
  • a supranational institution (which issues 'supranational bonds').

Bonds can be bought through an initial offering, that is, when they are first offered to the public (on the primary market), or subsequently from existing bondholders (on the secondary market). In the latter case, bonds are purchased at market price.

There are different types of bonds, each with distinctive characteristics.

Depending on their yield, ordinary bonds that pay interest can be:

  • fixed rate, guaranteeing the periodic payment of a set amount of interest;
  • floating rate, for which the interest paid is indexed to financial (usually Libor, Euribor or other official rates), real (the inflation rate) or currency-related (the exchange rate) benchmarks.

Interested parties

Investors in search of a periodic return that i) is higher than just leaving their money in a savings account or investing in government securities, and ii) provides a guaranteed cash flow, since the risk - while it exists (and is linked to the failure of the issuer) - is nonetheless smaller than that of investing in, for example, shares.

Issuers view bond placement as an alternative source of funding to obtaining a bank loan since it enables them to raise funds with longer maturities and at better interest rates than those offered by banks.

Strengths and drawbacks

Bonds can be the best instrument for investors who want to preserve their capital and be guaranteed a stable return. Floating-rate bonds, in particular, offer returns that are always in line with those of the market.

However, you should make sure you fully understand how bonds work, as well as the potential returns and risks. Risks include:

  • 'interest rate risk', given that changes in interest rates lead to changes in bond prices and therefore the possibility of a loss if the bond is sold before maturity. This risk is higher for fixed-rate and/or long-term bonds than for floating-rate bonds;
  • 'credit risk' or 'issuer risk', relating to the failure to pay interest or the failure to repay the principal at maturity;
  • 'liquidity risk', which refers to how difficult it is to sell the bond before maturity and is generally greater when there is a small or non-existent secondary market for the bond. It could prove especially difficult to dispose of unlisted bonds;
  • 'exchange rate risk', owing to the variability of the exchange rate between the currency in which the bond is denominated and that of the bondholder's country.

Subordinated (or 'junior') bonds are bonds whose principal is repaid in the event of the issuer's insolvency only after ordinary creditors and higher priority 'senior' bonds have been repaid. In exchange for greater risk, the bondholder is guaranteed a higher yield. That is why they are considered to be an intermediate instrument somewhere between a bond and a share and it requires particular care and skill to invest in them.

In the specific case of subordinated bonds issued by banks, there are currently in circulation four distinct classes of bonds, classified on the basis of their level of risk (in ascending order): Tier III; Lower Tier II; Upper Tier II; Tier I. The category of Tier 1 is the riskiest since these instruments give priority only over holders of ordinary or savings shares, but are subordinate to the claims of other creditors; they have no maturity date (although the issuer has the right to redeem them after 10 years); the coupon can also be cancelled if it is decided not to distribute dividends.

Expenses

The costs linked to investing in bonds consist mainly of the fees owed to the intermediaries involved in their purchase and sale and in their safekeeping (it is necessary to open a 'securities account').

Any income from bonds is subject to taxation.

Underlying rules

Those who invest in this instrument have a credit claim against the issuer for the periodic coupons and the redemption of the principal at maturity.

Pitfalls

A lack of diversification: The value of a single bond is linked to the fortunes of a single company, therefore it is highly risky to possess just one category of bond. The risk could be reduced by diversifying, i.e. by investing in different types of bonds (for example, in different commodity sectors or countries). However, this practice is still not sufficiently widespread, especially among small investors.

The risk-return ratio: we often fail to take into consideration the close correlation between risk and return. The return increases as the reliability of the issuers decreases because creditors demand higher compensation for the greater risk assumed. You should therefore be cautious when considering bonds with particularly 'attractive' interest rates.

Establishing a coherent time horizon: investing wisely means paying attention to your real goals and financial planning. Fixed coupon bonds with very long maturities may be subject to price fluctuations that compromise the return on the investment. In addition, you should consider the impact of inflation, which could affect the value of the coupons and, more importantly, the principal at maturity. You should also keep in mind that unlisted bonds are more difficult to resell before maturity, and therefore you cannot be certain of being able to use them to cope with unexpected and urgent cash flow requirements.

Keywords

COUPON

A bond coupon represents the interest that is periodically paid to the bondholder as a percentage of the value of the bond.