Many investors, when constructing a portfolio, avoid incorporating bonds as an asset class.
This is a pity because bonds can often play an important role. Bonds give diversity and, in most cases, the risk involved is low.
Whilst bonds are to be found in almost every country in the world, many nationalities are completely unaware of what they are and how they work.
North American and continental European investors usually have at least a basic working knowledge of how the bond market operates but very few investors of other nationalities are well informed.
Bonds come in various forms but a “standard” bond is basically a fixed income investment that can be issued by a government, municipality or private company. In all cases bonds have credit ratings which are issued by credit rating agencies such as Moodys, Standard & Poor’s and Fitch. The credit rating is of vital assistance to investors as it indicates the level of risk that is involved with the bond.
An example of this would be the highest credit rating of triple A if a bond had been awarded this level by standard & Poor’s. Moodys have a different system and their equivalent is A1. In both cases this means the highest credit rating possible.
The credit rating agencies have two different categories of risk, the highest is termed “investment grade” which covers not only triple A credit ratings but much further down the rating scale. At a predetermined point investment grade bonds reach a floor and anything below that is called “speculative”. That is a polite term used by credit rating agencies; the rest of the world simply calls “speculative” credit ratings “junk”.
Bonds can be issued for various periods of time i.e. two years, five years, ten years and even fifty years. The shorter time periods up to ten years are commonly used by both individual and institutional investors, very long dated bonds are usually only found in institutional investors such as pension funds.
In its basic form a bond is similar to a fixed deposit with a bank. The investor simply buys a bond knowing in advance the interest rate that is applicable and the maturity date of the bond. This type of certainty helps individuals to be able to plan their personal finances. Many retirees favour bonds as they give a secure and regular income flow.
A traditional bond usually pays interest every six months. Investors often buy different bond issues and by choosing bonds with different interest periods it is possible to have a quarterly or even monthly income at a fixed level.
Whilst there are some similarities between bonds and fixed deposits there are also differences. One of the most noteworthy differences is the ability to encash the investment. Banks issuing fixed deposits will sometimes allow early encashment but if they do they will usually levy an extra charge.
Bonds have a vibrant “second hand” market which allows investors the ability to buy and sell at will.
Any large bond offering with a good credit rating is a very liquid instrument meaning that they can be sold instantly. In fact, global bond markets have a much higher turnover than stockmarkets.
The “second hand” value of any bond is not guaranteed in advance, it all comes down to the market price.
Many variables impact on the “second hand” price of a bond in most cases the most important usually being the current level of interest rates pertaining to the period to the maturity of the bond. An example may be of assistance. An investor buys a bond of high investment grade with a period of ten years to maturity. After five years the investor needs access to the capital of the bond therefore the bond has five years to maturity. What the investor is actually selling is a five year bond. If we assume that the investor originally was promised 6% a year interest on the bond and the current rate of interest on a five year bond is only 4% then the investor is in the very fortunate position of not only being able to sell the bond but to do so at a profit. Bonds are usually issued at “par” that being 100% of the issue price and on maturity the investor receives a return of 100% of capital. The example, however, has a bond being sold with a higher yield than the market expects. To balance this, the value of the bond rises therefore the investor should be able to sell the bond for around 110% of its face value. This is referred to as “over par”.
Where interest rates rise the opposite occurs and bond values would result in a loss to investors; however, if the original investor can hold the bond to maturity, then 100% of the capital will be returned.
There are many different types of bonds, one common variant is the “zero coupon bond”. This term “coupon” is simply bond terminology for interest payments. A “zero coupon bond” therefore does not pay out interest. This type of bond appeals to investors who want to add certainty to a portfolio in the form of a capital gain.
A “zero coupon bond” with a seven year term may be issued at, say, 65% of the maturity value. It then matures, seven years later, at 100% , that is, it is bought for 65% of its value and pays out 100%.
In a similar manner to traditional bonds, zero coupon bonds can be traded at any time.
More on bonds in later articles.