In the broad realm of financial markets, there are various asset classes, including equities, foreign currencies, cryptocurrencies, commodities, or real estate, each playing an important role in the markets and for investors across the world. One key asset class is fixed income, and this is traditionally considered one of the main and most important asset classes in finance. Fixed-income securities include banker’s acceptances, guaranteed investment certificates, and more. In this article, we will specifically be looking at bonds, which is perhaps the most well-known fixed-income security. We will explore what bonds are, how they work, some examples of specific bonds, along with a few potential risks that come attached to this widely considered ‘safe’ investment.
What are bonds?
In short, bonds are an effective way for governments, but also corporations, to raise money in order to finance new projects or even continue current operations. Such institutions will issue bonds that investors can buy, and in return, investors will receive interest payments at a fixed rate (coupon rate). The bond also has a maturity date, and at this date, investors will get back the money they initially invested (principal): in most cases that is. A good way to think about buying bonds is like loaning an institution money, in return for interest payments and future reimbursement.
How do they work?
To fully understand the concept of bonds, let’s use a very simple example, in this way, we will also be able to see how investors make a return on their initial investment. Be it completely fictional, but let’s say that a government needs money to build a new motorway, it could choose to issue bonds to raise this money. As mentioned above, bonds come with a maturity date, so, assuming the face value of the bond is £5,000, the coupon rate is 4% and the maturity date is 10 years from now, the investor will receive £200 per year in interest payments (5000 x 0.04), and in 10 years’ time, the investor will get back the £5,000.
This coupon rate will not change, meaning that the investor will receive these interest payments each year. However, just like any other financial instrument, the value of a bond can fluctuate due to an increase or decrease in demand, meaning that investors do not have to hold the bond until the very end of its maturity. For example, should interest rates rise, the demand for bonds is lower, which in turn drives the price of a bond down, and vice versa.
This is where bonds can be used to generate further income. Should the price of a bond be driven lower than its face value, this means that an investor experiences higher returns on their investment, as not only will they continually receive interest payments, but when the maturity date comes around, they will receive a payment for the face value of that bond. This is why investors look at the yield to maturity rate, as this calculation allows them to consider what the percentage rate of return on their investment could be, should they hold the security until the maturity date. This rate will naturally fluctuate with the price of the bond.
Think of it this way:
Lower bond price = higher yield as the bond is trading at a discount.
Higher bond price = lower yield as the bond is trading at a premium.
YTM formula Source: Investopedia
Should you be interested in the actual calculation, you can see it above, but there are many online calculators that can be used for this function, you can also simply follow most financial news outlets to find such information.
Examples of Bonds
There are so many different types of bonds, far too many to cover in this short piece, so if fixed-income securities have interested you so far, then there is so much more to explore. However, the following bonds will hopefully give you a brief idea of the types of securities available today.
Government bonds are typically considered as very low-risk investments, given that the government is the body making interest payments. Governments are particularly stable and have an obligation to the people of a country, therefore, they are less likely to default in comparison to companies, which can of course go bankrupt.
Overall graphic of U.S Treasury Bonds – 5, 10 and 30-year maturity dates Source: Bloomberg
Government bonds can be issued by the federal government, for example, the U.S Treasury, but also by municipalities. U.S Treasury bonds are particularly popular; these include the U.S 10-year Treasury bond (GT10:GOV) and the U.S 30-year Treasury bond (GT30:GOV). Such bonds are auctioned by the U.S Treasury every year and definitely worth considering as a form of ‘safer’ investment. For more information on using TreasuryDirect and the process of buying federal securities on this platform, Investopedia has a great piece you can check out here.
Corporate bonds are another possibility; these are bonds issued by individual companies seeking to generate capital to fund operations and projects. However, in comparison to government bonds, they carry more risk as corporations can, as mentioned above, go bankrupt. On the other hand, it is also worth noting that corporate bonds pay higher yields due to this risk.
These bonds can be purchased in an initial offering by the company, but also on exchanges such as the New York Stock Exchange. Additionally, there are corporate bond ETFs, allowing investors to essentially spread risk over numerous bonds instead of placing large amounts of capital in the hands of one company, though this does mean that the coupon payment will be paid monthly and will also vary. A couple of ETFs you may want to check out include the iShares iBoxx $ Investment Grade Corporate Bond ETF and the Vanguard Intermediate-Term Corporate Bond ETF. Through such ETFs, investors can access investment-grade corporate bonds, a rating signifying that there is a low risk of the debtor defaulting – they are therefore normally safer. But more on ratings later…
ETF Database has a great list of potential ETFs in this sector which you can find here.
When looking to buy a house, a person may go to the bank and request a mortgage. Rather than the bank lending all the money and having to wait for each installment of the homeowners' mortgage payments, an investment bank can buy this mortgage along with several others and pool them together to create a bond for investors to buy. If homeowners continue to pay their mortgages, this is the ideal scenario, as a proportion of the interest they pay on the loan is used to provide the ‘fixed income’ for investors. Agencies such as the Federal Home Loan Mortgage Association and the Government National Mortgage Association issue such securities, but just as with corporate bonds, there are various ETFs for mortgage bonds, these include the SPDR Portfolio Mortgage-Backed Bond ETF and the Vanguard Mortgage-Backed Securities ETF. But as always, remember to fully research all options before purchasing any securities.
The term ‘mortgage bonds’ often has negative connotations due to people defaulting on their mortgages, triggering the housing collapse and subsequent financial crisis of 2009. However, this type of bond is often considered safer than corporate bonds due to more rigorous mortgage application processes, and the fact there is a physical property backing up the security. This lower risk level, just like government bonds, means that the yields of mortgage bonds are lower in comparison to high-yield bonds, junk bonds, and corporate bonds.
Risks and Drawbacks
While bonds are a great way of essentially keeping money safe, generating extra income from interest payments, and even helping fund local or wider scale projects of companies and governments, bonds are not risk-free.
Liquidity Risk – Not really something to worry about with U.S Treasury bonds as these bonds are very liquid (lots of buyers and sellers), but in comparison to equities, there is a risk that you may not be able to buy and sell bonds as quickly as you wish. This may mean that you are left stuck holding a bond during a time in which it may be more profitable for you to sell it.
Monetary Policy – Changes in factors such as interest rates will impact the bonds an investor holds. As we have already discussed, rising interest rates will decrease the price of the bond relative to its par value. Therefore, if you ever need to sell the bond to benefit from higher interest rates (as they may become higher than your coupon rate), your ROI will almost certainly be lower. Furthermore, this is also where holding bonds with much longer maturity dates could be considered a risk – there is much more time for events to occur in the markets and in the economic and political spheres that could negatively impact your investments in fixed-income securities.
Default – Finally, and perhaps most importantly, there is still a risk of default, which would mean that you would lose your entire investment. To combat these risks, always be sure to consider the rating of a bond from an established ratings agency, as their assessments can help us understand how likely a bond issuer is to default. Though it should be noted, these agencies may not always be correct in their valuations.
How ratings agencies classify bonds
As you can see, triple-A rated bonds are undoubtedly safer. Whilst poorly rated bonds known as junk bonds (rated C, CC, and so on) provide the potential of realising significantly larger gains, the bonds are certainly much riskier when considering the likelihood of default.
Bonds, as a fixed-income security, are undoubtedly a great way to generate a form of passive income whilst helping an organisation or governmental body. Furthermore, they are useful to weather economic downturns and low interest rates thanks to the regular interest payments, all with the promise of regaining the principal investment. Much like any investment, bonds still carry risks, such as default and rising interest rates, however, if selected correctly, bonds go a long way in helping to establish, maintain and protect a fully diversified investment portfolio.
Naturally, this short article has merely touched the surface of the broad topic of advantages and disadvantages of bonds, so be sure to do your own research either to simply learn more, or before purchasing securities. Let us know your thoughts on this fixed-income security in the comments!