Introduction to Bonds

By Andrew He, Gary Palar, Samuel Subramaniam

In UNIT’s first two pieces in our Intro to Investing series, ‘What is Investing’ and ‘Introduction to Stocks’, we covered why you should think about investing. Then, we followed this with a basic understanding of what stocks are. If you’re new here joining us, we suggest you take a read of them first.

If you remember from last time, a stock was defined as “an ownership stake in a business”. In this segment, we will cover bonds. In any discussion within investing and trading, it is very helpful to know the differences between the two.

First, why are we worrying about bonds in the first place?

As of 2018, the actual size of the bond market is around 38% larger than the stock market. There are 10 times more debt issued than equity!

Comparing the equity and bond markets trillions — And, take a look at this chart. This is the risk and return of different bonds, and the S&P500 Index which represents stocks.

Not all bonds are created the same, and we’ll go into why later. But, you can expect the returns on bonds to be 5.3% (based on the U.S. bond market from 1926-2018). Also notice, as with stocks, that although there are many different types of bonds they have a lower risk and return than stocks.

Bond performance 1976 to 2016 risk and return — Source: Engineered Portfolio

We’ve previously talked about risk and return and we took note stocks are the riskiest forms of investments compensated by a higher return. Stocks make the most sense for the long term. But how about for people closer to retirement? Can they handle risking 30% declines in the share market? What do people do when their tolerance for risk decreases? Older individuals usually move to assets with lower risk to diversify their portfolios. This is where the role of bonds comes into play.

So to get started,

What is a bond?

To understand a bond, it is easier to understand a loan first. A loan is an agreement (usually for money) between two parties. One of the parties is the lender (‘creditor’) who lends money. Naturally, the other is called the borrower (‘debtor’) who borrows money and promises to pay it back, plus extra (called ‘interest’) for borrowing in the first place.

Buying a bond means you, a new ‘bondholder’, lend money upfront to the borrower, or ‘issuer’, for an agreed period of time until ‘maturity’ of the bond, maturity can range from several months to years. When the bond matures, the issuer pays out an amount originally agreed – the ‘face value’ of the bond – and clears their debt. Depending on the type of bond, ownership until maturity also means you are entitled to receive a regular ‘coupon’ ( ‘interest’) payment once or twice a year. These types of bonds are called ‘coupon’ bonds. Bonds that do not have regular interest payments are called ‘zero-coupon’ bonds. ‘

Just to clarify, zero-coupon bonds don’t pay out coupons. Initially, when you buy this bond you normally pay less upfront, than if it were a coupon bond, to the face value. But same as with the coupon bond, the bond issuer will pay you out the face value of the bond at maturity.

The difference between bonds and loans

A key difference between a bond and a loan is: the bondholder can sell the bond to another party, and they can become the new bondholder. Of course, this means the new bondholder can sell it again to another, and so on. This means bonds can be traded unlike loans.

So, the difference between bonds and stocks

Unlike stocks, if you own a bond you don’t own the other party. You’re simply lending to them.

Being a stockholder means you have an ownership in the company. However, as a bondholder, you are a creditor, and can only expect the company to pay back the debt owed. Another key difference is, if the company defaults, the company will need to pay back the debts to the bondholders first. If there is any leftover money, it will then go to the shareholders.

Government vs Corporate Bonds

There are two main issuers of bonds, which provide a starting point to how we discuss their risks and return. These are government bonds and corporate bonds. Bonds issued by governments are usually safer, hence have a lower risk. Some reasons for this include governments having more flexibility – such as through raising taxes – to pay off debt. In saying that, it doesn’t mean countries are immune to ‘default’, the failure to repay a debt.

Take the Greek government-debt crisis since 2009 as an example of this. We’d suggest further reading to make sense of it. Hence, a better way to discuss the risks and returns of bonds links to ‘credit rating’.

Risks of bonds: Credit Ratings

Although investors often counterbalance the riskiness of stocks with bonds, bonds have their own risks too. From the safest AAA (triple-A) credit rating all the way down to the already defaulted D credit ratings, these four letters allow investors to quickly assess the creditworthiness of a nation, company or a bond.

Credit rating scales by agency Moody's S&P and Fitch, long term

As discussed in ‘What is Investing?’, and previously above, the investor’s toolkit involves the idea of risk and return; often the more risk an investor is willing to stomach, the higher return (called the ‘yield’) they can expect to receive. The AAA-rated bonds are the safest, but as mentioned, they will have lower yields. On the other hand, the Bs are riskier, but they offer higher returns.

Where do the ratings come from?

If you’ve read the business section of any newspaper, you probably have heard about ‘Moody’s’ or ‘S&P’ or ‘Fitch’. These are credit rating agencies – independent bodies tasked with assigning those exact letters to government bonds, corporate bonds and other debt instruments.

They ask themselves “what is the likelihood that this corporation won’t make timely interest and face-value payments?” – basically, “what is the probability of default?” by looking at their level of debt, interest payments and cash flow amongst other metrics.

How are bonds traded?

Similar to stocks, where you can buy a stock at IPO, bonds can be bought at a public offer when they are first issued and this is known as the primary market. Afterwards, you can buy corporate bonds listed on bond exchanges or ‘over-the-counter’ (OTC). The OTC market is decentralised, which means it is traded by broker-dealers and the price is reported on separate transactions, rather than being traded at the last price on a listed exchange.

Trading over the counter provides more ‘liquidity’ for investors to sell bonds before maturity. Also, the average size of a bond trade is substantially greater than for an equity trade. Xtrakter data indicates the average size of a bond trade is between $1 to $2 million, while trades in excess of $2 to $5 million are more common. With these large size trades, the buyer and seller will sometimes negotiate a price between the dealer and this can be only done over the counter.

When buying bonds on the secondary market you also have to pay a small brokerage fee around $10. Similar to stocks, you can buy bond Exchange Traded Funds (ETFs) which are portfolios of bonds that aim to track the return of the bond index. This way you don’t have to pick individual bonds to invest. We’ll go into more detail on ETFs in future articles.

How bonds can earn you money?

There are two ways a person can earn money through investing in bonds: capital gains and holding them to maturity while collecting coupons.

Capital gains are the increase in the bond price. If you bought $10,000 worth of bonds at face value and later the market value of these bonds increased to $11,000 and you sold them, you pocket the $1000 difference minus any brokerage costs during the trade.

Coupon payments are the regular payments made by the issuers to bondholders to ‘service’ the bonds. If you are a long term investor in a bond and hold the bond to maturity, the issuer will pay the face value of the bond plus coupons. For example, if you hold a 10-year bond with a coupon rate of 3%. The bond issuer will pay you $30 every $1000 in face value you own every year until maturity.

The difference between coupons and dividends (the payments from stocks), is the certainty of coupons compared to dividends because they are an obligation, agreed in writing and at the initial issuance of the bond. The coupon rate does not change. This is unlike dividends, where the company has discretion over the payment frequency and amount.

Conclusion

Bonds are the main tool investors use to balance a portfolio of other riskier investments. Due to its lower risk, investors usually allocate more of their wealth to bonds as they get older. However, it is ultimately up to you on how much risk you want to take and what you want to achieve with your investments.

Stocks and bonds are not the only assets you can invest in: Keep an eye out for the next part in this series which will be coming soon: ‘Introduction to Property’.

Well done for making it to the end of the article! We hoped you learned something from this! If you have any questions about this article or any other articles written by us, feel free to let us know either through messaging us through Facebook ‘UNIT – University of Melbourne’

Sources: Engineered Portfolio, Vanguard

So, what can you do now to learn more about investing?

This semester, UNIT is publishing an article for beginners interested in investing every fortnight.