What are bonds and how do you use them?

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20 October 2023
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What are bonds?

Bonds are financial instruments that express debt obligations, they are actually debt receipts. When you purchase a bond, you are actually making a loan to a large organization, government, or other issuer. In exchange for your loan, the issuer promises to pay you interest for a certain period of time (coupon payments) and to return the original amount (the face value of the bond) to you at the end of the term. By purchasing a bond, an investor makes a loan to a company, government, or other borrower with the expectation of receiving a certain return in the future.

Bonds are one of the instruments for obtaining fixed income, as the yield from them is known in advance. These instruments are widely used as investments to generate stable income and as a means of diversifying a portfolio.

Types of bonds

There are several types of bonds. The differences may be related to the issuer, maturity, repayment terms and other parameters. There are several characteristics by which bonds can be classified.

By issuer:

Corporate bonds: issued by private companies to raise capital. The yield depends on the creditworthiness of the issuer and the term of the bond.

Government bonds: issued by various governments. They are considered one of the least risky because the government is often considered a stable borrower.

Municipal bonds: issued by local governments (cities, regions) to finance various projects.

Investment and structured bonds: Banks, brokers and management companies issue investment and structured bonds to raise money from investors. These funds are then often invested in various securities in order to earn management fees and profits on these assets.

Commercial bonds: issued by private companies to raise capital for their operations. These bonds may have different terms, coupon rates and maturities depending on the company's financial position and current market conditions. They are often distributed on a targeted and private subscription basis, meaning that they cannot be bought easily.

By form of income payment:

Fixed Income Bonds: provide fixed interest income that is paid to the bondholder over the life of the bond.

What are the different rates of return?

  • Fixed: In most cases, bonds have a rate of return that remains constant over the life of the bond. It can be a constant rate, where the same interest is paid for each period, or a rate where the interest varies for each period but is known in advance.
  • Variable: some long-term bonds have a variable rate. Initially a fixed rate is set, but after a certain period, the issuer has the right to change the interest according to market conditions.
  • Floating: Floating rate bonds offer the greatest uncertainty in returns. Interest on them is linked to macroeconomic indicators such as inflation or the key rate, making their returns less predictable.

Discount bonds - are a type of bond that are sold below their face value. The difference between the purchase price and the face value is the discount, which is a form of interest income for the investor.

When buying discount bonds, the investor pays less than the face value of the bond. For example, if a $1,000 face value bond sells for $900, the discount is $100. At the end of the bond's term, the investor will receive the face value back, allowing the investor to make money on the difference between the purchase price and the face value. Discount bonds are often used by governments or companies as a way to raise capital.

Index-linked bonds - are bonds whose face value changes according to a specific index or indicator. This type of bond is designed to protect investors from the effects of inflation.

When an investor purchases an index-linked bond, the face value of the bond automatically adjusts to changes in the index to which it is linked. This means that if the inflation rate rises, the par value of the bond also rises, which compensates for losses from monetary deflation.

Index-linked bonds are usually linked to the consumer price index or other key economic indicators. This type of bond provides investors with inflation protection, preserving the real value of their investment in the face of changing prices.

Structured income (investment grade) bonds are a type of bond in which the yield structure depends on certain characteristics or conditions related to the issuer or the project financed by the proceeds of the bond. Structured yield bonds typically utilize some form of special terms and conditions that may vary depending on certain events. For example, structured income may be tied to the issuer's financial performance, stock returns, sales of goods or services, inflation, and so on.

Here is an example for better understanding: let's imagine that a company decides to issue bonds to finance the construction of a new plant. They may decide to use structured yield bonds. In this case, the yield structure may be related to the production or sales volume of products in the new plant.

An example of a structured income:

  1. Base coupon: 4% per annum (fixed coupon).
  2. Bonus Coupon: Additional 1% per annum if production exceeds a certain level.

Thus, if the production volume of a new plant is above a certain level, investors receive additional income in the form of a bonus coupon. However, if the volume does not reach the specified level, investors receive only the basic coupon.

There are also bonds of this type, where interest will be paid to investors only if predetermined conditions are met: for example, a company issues investment bonds to finance its clean energy project. The terms of the bonds are as follows:

  • If the company achieves its stated level of renewable energy production, the coupon for investors is 15%.
  • If the company's environmental energy sales are higher than the level stipulated by government standards, the coupon is increased to 20%.
  • If the company fails to meet the established environmental standards, no coupon is paid.

However, the amount invested is returned to the investor in full regardless of the fulfillment of the terms of the investment bonds.

Structured bonds are a type of bond with a non-standard yield structure or special terms that may include additional payments that depend on certain factors or events. This structure is designed to tailor the bond to the specific needs of the issuer. Let's say a company issues structured bonds linked to the stock performance of four different companies - A, B, C and D. The terms are:

  • If the stock prices of all four companies rise by more than 10% over the bond period, the coupon will be 20%.
  • If at least one of the companies goes down more than 10%, but not more than two, the coupon will be 12%.
  • If at least two companies drop in price, bondholders will receive only 80% of face value at maturity.

This creates a structure where returns depend on overall market dynamics and the success of a few companies. Investors receive a higher coupon when share prices rise, but there is a risk of losing up to 20% of the par value if prices fall for two or more companies.

By maturity:

Short-term bonds: their maturity is less than a year.

Medium-term bonds: have a term of 1 to 5 years.

Long-term bonds: their maturity exceeds 5 years.

Perpetual or perpetual bonds: have no set maturity date.

On convertibility:

Convertible bonds: can be exchanged for other securities of the same issuer, such as shares.

Non-convertible bonds: no exchange for other securities.

By endowment:

Secured bonds: such bonds are secured by specific assets or collateral. If the issuer defaults on its obligations, holders of secured bonds are entitled to the collateral assets as compensation. The collateral can be anything - real estate, company equipment, other securities. In case of bankruptcy of the company, investors receive collateral assets, which can be realized to return all or part of the invested funds. Another form of collateral is the guarantee of another company, which will assume the obligations under the bonds if the issuer is unable to fulfill its obligations. The third option includes bank, state or municipal guarantees, acting similarly to a surety. In this case, in the event of a financial crisis of the issuer, the bank, local or federal government guarantees the repayment of bond debts, thus providing protection for bondholders.

Unsecured bonds: have no specific assets or other type of collateral as security. Holders of unsecured bonds rely on the general creditworthiness of the issuer. In the event of bankruptcy, bondholders will have to wait for the bankruptcy process to be finalized before their claims can be processed, let alone discharged.

Backed (or senior) bonds: such bonds have a priority right to redemption over other types of bonds of the issuer. In case of bankruptcy of the issuer, holders of backed bonds will be the first to receive compensation.

Subordinated unsecured bonds: these bonds typically have a higher level of risk than other categories of bonds, providing holders with a higher yield as compensation for this. These bonds have a lower priority in the order of repayment. In the event of bankruptcy or liquidation of the issuer, the subordinated unsecured bonds will be repaid only after the claims of higher priority obligations, such as senior notes and other company obligations, are satisfied. And there is little left at the very end, which is why, because of the higher risk of non-repayment to holders, such bonds provide a higher rate than less risky bonds.

By mode of circulation:

Free float bonds: can be freely sold and bought on the secondary market without any restrictions or special conditions. Holders of free floating bonds can transfer them to other investors at their discretion.

Restricted bonds: have restrictions on transfer and circulation. They can usually only be sold or transferred in accordance with certain conditions set by the issuer. These conditions may include the issuer agreeing to the transfer, providing documents, holding the bonds for a predetermined period of time or complying with other restrictions that may be imposed by the holders or the issuer.

What's the bond yield?

Bond yields depend on several factors and can be measured in many ways. But now we will look at the key aspects that can be used to determine bond yields.

Coupon yield is the yield on the interest rate specified in the bond itself as the annual coupon payment as a percentage of the face value. For example, if a bond has a face value of $1,000 and a coupon of 5%, the coupon yield will be $50 per year.

The yield at par is the yield expressed as the ratio of the current annual coupon to the current price of the bond. For example, if a bond with a coupon of 5% is sold for $900, the yield at par will be approximately 5.56% ($50/900$).

Yield to maturity - yield with an estimate of the expected annualized yield, taking into account coupon payments, the current price of the bond and the time to maturity. Yield to maturity takes into account the capital investment and all future coupons, assuming the bond is held to maturity.

Suppose you have a bond with a face value of $1,000, a coupon of 5% paid annually, and a remaining term to maturity of 3 years. The current price of this bond in the market is $950.

Coupon payments:

  • Year 1: 5% of $1,000 = $50
  • Year 2: 5% of $1,000 = $50
  • Year 3: 5% of $1,000 = $50

Expected coupon return over three years:

  • 50$ (year 1) + 50$ (year 2) + 50$ (year 3) = 150$

Estimation of expected annualized returns:

  • Current price of the bond: $950
  • Future value (face value): $1,000.
  • Term to maturity: 3 years

Calculation of expected returns:

  • Annual yield: ($150/950$) * 100 ≈ 15.79%

Therefore, the expected yield to maturity (YTM) for this bond is approximately 15.79%. This takes into account the coupon payments, current price and term to maturity, assuming the bond is held to maturity.

Current Price Yield: This is the ratio of the current annual coupon to the current price of the bond. Suppose you have a bond with a face value of $1,000, a coupon of 5% paid annually, and a current price of $950.

Coupon payments:

  • 5% of $1,000 = $50

The current price of the bond:

  • 950$

Calculation of yield at current price:

  • Annualized yield = (Coupon payments/Current price) * 100
  • (50$/950$) * 100 ≈ 5.26%

Thus, the yield at current price for this bond will be approximately 5.26%. This figure is the ratio of the annual coupon payment to the current price of the bond and gives an idea of the expected yield for an investor who buys the bond at the current price.

Bonds with high coupons purchased at a discounted price are considered the most profitable. However, it should be remembered that the higher the coupon and the greater the discount, the higher the risks associated with these investments. Government bonds, in turn, are the least risky: they usually have smaller coupons, but the chance of losing by investing in them is much lower. U.S. government bonds take the leading position among bonds of this type - they are considered one of the most reliable.

What is a bond yield curve?

A bond yield curve is a graph showing the relationship between a bond's yield (or rate of return) and its maturity. This graph allows investors and analysts to evaluate how yields vary with the term of the bond.

Types of bonds
What are bonds

At the moment, using a graph of the bond yield curve, we can see that one-year bonds are the most profitable, while 10-year bonds are the least profitable. However, this is not a good sign for the country's economy as a whole. Why? There are several shapes that a yield curve can take and they can change depending on market conditions, each one carrying information about the market and possibly the future:

  • Normal yield curve: bonds with longer maturities have higher yields.
  • Invested yield curve: in this case, bonds with shorter maturities have higher yields, which can be an indicator of an upcoming economic downturn.
  • Flat yield curve: bond yields do not vary significantly with maturity. This may indicate uncertainty about future economic conditions.

The yield curve on government bonds can fluctuate due to various factors such as changes in Federal Reserve rates, inflation expectations and geopolitical events

In this case, we have an inverse yield curve in front of us, because the yield from short-term bonds is higher than from long-term investing. I suggest to talk about it in more detail. An inverse or inverted bond yield curve is very often associated with a possible future recession. Thanks to the graph of the bond yield curve, a recession could be predicted every time. An inverted yield curve occurs when interest rates on short-term bonds become higher than on long-term bonds. Such a yield curve can mean that investors expect the economy to slow down and central banks may lower interest rates.

How are central bank interest rates and the bond yield curve related?

When investors expect the economy to slow down and interest rates to fall, they may change their investment strategy, which affects the bond yield curve.

  • If investors believe that the central bank will lower interest rates, they may prefer to buy long-term bonds with higher interest rates to lock in a higher return in advance.
  • When investors actively buy long-term bonds, their prices rise, causing yields to fall. This creates a situation in which interest rates on long-term bonds can be lower than on short-term bonds, and hence an inversion of the yield curve occurs.

This is why central bank interest rates, the global environment and a country's overall monetary policy have a significant impact on investors' decisions by shaping the yield curve.

The inverted yield curve is becoming an indicator that some economists and investors view as a warning of a possible recession. However, it is important to remember that while the inverted yield curve has a 100% statistic of predicting prior recessions, it is not an absolute guarantee and a recession may not always follow.

What are the risks in bonds?

Despite the fact that investing in bonds is quite safe, risks are also present:

Credit default risk is the risk that the issuer of a bond will be unable to pay interest on coupons or return the principal at maturity. Bonds with lower credit ratings generally have a higher risk of credit default.

To give an example: during the 2008 crisis, credit default risk was a major factor affecting bonds and, in particular, U.S. bank bonds. The crisis began with problems in the mortgage sector, particularly among subprime mortgages (high-risk loans to borrowers with low credit ratings). Many of these loans were packaged in complex financial instruments. Various types of bonds, including mortgage-related securities and collection instrument bonds, became targets of exacerbated credit default risk. The fall in the value of these bonds had a cascading effect in the financial markets. Many U.S. banks owned mortgage-related bonds, and when the prices of these bonds collapsed, banks faced losses and credit default risk, and investors, in turn, lost their investments - some partially and some completely.

Economic factors are risks that represent some of the key aspects when investors consider bonds.

This includes:

  • Inflation risk: high inflation may reduce the real value of future cash flows, such as coupons and repayment of par value;
  • Fed Funds Rate: changes in Federal Reserve rates can affect bond prices. Higher rates may cause a decline in the prices of existing bonds;
  • Economic stability in the issuing country (when it comes to government bonds): economic difficulties or instability may affect the government's ability to repay the debt.

Commitment restructuring risk: it consists of the possibility of the issuer changing the terms of the bonds, including maturity, coupon rate and payment schedule. The issuer may offer new terms to investors if it faces difficulties in meeting its original obligations.

Liquidity risk: bonds may be less liquid than equities, especially if they are low-rated bonds. If it is necessary to sell the bond, the investor may face difficulties in finding a buyer at a favorable price.

Main advantages and disadvantages of bonds

Bonds are one of the key financial instruments that provide investors with an opportunity to generate income and diversify their portfolio. That's why let's take a look at their advantages and disadvantages.

Advantages of investing in bonds

Income stability: bonds provide a stable and predictable stream of income in the form of. As a rule, when investing in bonds, the investor knows in advance the interest he will receive in the future, or is given information with which to calculate it.

Low risk: compared to investing in stocks or cryptocurrency, bonds are less risky investments, especially government bonds or bonds of companies with good payout ratings.

Portfolio diversification: including bonds in a portfolio can help reduce overall risk through diversification.

Priority in redemption: in case of bankruptcy of the issuer, bonds have priority in receiving funds over shareholders.

Disadvantages of investing in bonds

Low returns: compared to other investment instruments such as stocks and cryptocurrencies, returns from bonds (especially from reliable issuers) can be relatively low.

Interest rate risk: when interest rates change in the market, bond prices can fluctuate, which affects the value of the portfolio. You can sit with a bond for 2 years and end up with less than you expected (not applicable to all types of bonds).

Credit default risk: bonds with lower credit ratings are at risk of default when the issuer cannot meet its obligations.

Limited potential: unlike stocks or crypto-assets, bonds offer limited capital growth potential.

Lack of income: investment and structured bonds carry a high level of risk, which may result in no income or even losses.

How to choose the right bonds to invest in?

Selecting bonds for investment requires careful and thorough analysis and evaluation of various factors. First of all, an investor needs to decide which type of bond suits his goals - government, corporate, municipal or other. Then evaluate the credit rating of the issuer - a high credit rating indicates the stability and reliability of the issuer. One should pay attention to rating agencies such as Moody's, S&P and Fitch. The next step is to estimate the expected yield from the bond, taking into account coupon payments and potential changes in the market. You should also examine the coupon structure (fixed, variable, indexed) and choose one that fits your financial goals and preferences. Next, you should pay attention to the term of the bond. It is also very important to determine how liquid a particular bond is - is it easy to buy or sell on the market?

Only after an investor has analyzed all these factors can he or she decide whether to buy certain bonds. The choice of bonds depends on individual goals, risks and financial strategy. Careful analysis and an informed approach will help you make a more informed choice. It is also important to remember to diversify your portfolio, as this is what will help to reduce risk when investing in this type of asset.

Why does the government borrow money?

We've looked at investing in bonds and the advantages and disadvantages of such assets, but what makes them beneficial to issuers - why do governments issue bonds?

Issuing bonds for the government is no less profitable process than the purchase of such assets by an investor.

The state receives funds from investors who buy its bonds. These funds, in turn, become a source of capital for the realization of various state goals. In fact, these funds are an additional source for financing large infrastructure projects, social programs and budgetary needs. Issuing bonds provides the state with an additional source of funding beyond tax revenues. This reduces dependence on certain sources and provides greater flexibility in financial management.

It is impossible not to say that by issuing bonds, the government stimulates investment, as investors, buying government bonds, invest their funds in the economy of the country.

The government invests other people's money, pays interest on it to investors, so how do they make money?

The state is obliged to pay yield to bond holders and return the face value of the bond at its expiration - these interests are expenses for the state, but at the same time it uses the raised funds to realize its goals. The funds raised through bonds can be used to finance projects that stimulate economic development. This growth can in turn increase government revenues, which is an indirect way of generating profits that are often higher than the bond yields

In addition, with positive trends in the economic sector, the value of assets (government bonds) can grow, so that not only the investors who invested in the bonds, but also the issuer itself - the state - earn on this growth.

How does issuing bonds help commercial enterprises?

Large investment projects, such as building new enterprises, developing new products or acquiring other companies, require significant financial resources. Issuing bonds allows companies to attract capital on the market and use it for realization of such projects. That is why when commercial enterprises see that the realization of certain promising projects can bring good results in the form of income and at times cover the costs in the form of interest paid to investors, they decide to issue their own bonds.

In addition, companies can issue bonds to pay off old debt or restructure debt. This allows them to improve their debt profile, lower interest rates and improve overall financial conditions.

In essence, issuing bonds provides companies with a tool to effectively manage their finances, raise capital and realize their strategic goals.

Are bonds and bonds the same thing?

Yes, "bonds" and "bonds" are often used synonymously in the context of finance. Both terms refer to financial instruments that are debt obligations of the issuer to investors.

Is it worth investing in bonds: Cryptology team's opinion

Each investment vehicle is unique and offers different opportunities. Bonds are a good, proven and mutually beneficial instrument, which of course has a place to be.

Should you invest in bonds? Yes, but it's not so simple. Bonds are not suitable for every type of investor or every investment portfolio.

Like any investment, bonds have their pros and cons that should be considered before making a decision. To determine whether bond investing is right for you, you first need to decide:

- Desired profitability.
- Possible risks.
- Investment terms.
- What type of investor are you and much more.

Bonds are a valuable investment vehicle for those looking for stable income and safe assets in their portfolio, but such moderate returns are not for everyone.

Frequently asked questions about bonds

What are bonds?

Bonds are financial instruments that an issuer (government, company or other organization) issues to raise funds. Investors, by purchasing bonds, actually lend funds to the issuer. In return, the issuer agrees to pay investors a fixed income in the form of coupon interest for the duration of the bond. At the end of the bond term, the issuer also returns the nominal value to investors.

Is investing in bonds risk-free?

Bonds, like any other investment instrument, carry potential risks. One of the main risks is default risk, which is the possibility that the issuer of a bond will not be able to fulfill its obligations to pay interest or repay the principal at maturity. Typically, bonds with lower credit ratings carry similar risks. This is why it is so important to conduct a thorough analysis before investing in any bonds.

Why is the government borrowing?

Funds that come into the state treasury from the sale of bonds become capital to finance a variety of state programs and projects, which, in turn, indirectly affect the state's revenue from other other sources. Bonds are an effective additional source of state funding.
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