Most people who regularly invest in financial markets have some basic understanding of how bonds work. In their simplest form, bonds are just a loan that investors give to the bond issuer. The issuer in return pays an interest on the loan and pays back the principal at a pre determined rate.
However, there is much more to bonds than just interest and principal. The dynamics of a simple loan can change completely when a large number of investors are involved and the bond is freely traded in the market. If you are a serious investor in bonds, there are many concepts that you need to understand to properly analyze a bond investment and to make the right bond buying and selling decisions.
Table of Contents
Chapter 1: Categories of Bonds
Chapter 2: Pricing of Bonds
Chapter 3: Calculating Yield and Understanding Yield Curve
Chapter 4: Duration of Bonds
Chapter 5: Relationship Between Price, Yield and Duration
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Chapter 1: Categories of Bonds
– Categorization Based on Issuer and Credit Quality
– Categorization Based on Redemption Options
– Categorization Based on Interest Payments
– Categorization Based on Place of Issue and Denomination Currency
– Categorization Based on Priority of Payments
Chapter 1: Categories of Bonds
Most people who regularly invest in financial markets have some basic understanding of how bonds work. In their simplest form, bonds are just a loan that investors give to the bond issuer. The issuer in return pays an interest on the loan and pays back the principal at a pre determined rate.
However, there is much more to bonds than just interest and principal. The dynamics of a simple loan can change completely when a large number of investors are involved and the bond is freely traded in the market. If you are a serious investor in bonds, there are many concepts that you need to understand to properly analyze a bond investment and to make the right bond buying and selling decisions.
The first thing that you need to look at closely is the type of bond that you want to invest in. Bonds can be categorized based on several parameters, which determine their risk-return profile. Based on your risk profile, you can choose a bond that gives you sufficient returns without exceeding the risk too much. Here is an overview of different bond types.
Categorization Based on Issuer and Credit Quality
The credit quality of a bond directly depends on who is issuing it. This concept is very similar to the way a mortgage lender assesses the credit score of a potential borrower before offering the loan at a certain interest rate. When you invest in a bond issued by a risky entity with a low creditworthiness, there is a greater chance that the issuer will default on bond repayments. In case of a default, you are likely to lose out on some or all of your investment.
Bonds can be issued by the federal government, states and cities, companies and several other organizations. Bonds issued by the US government are considered the safest as there is almost no risk that the government will default on its obligations. One reason is that the government can simply print more money to avoid a default.
In fact, Treasury bonds, issued on behalf of the US government, are one of the safest investments in the world. You can also invest in bonds issued by the governments of other countries. But remember that not every country’s bonds carry the same risk. Bonds issued by politically unstable or economically weak countries carry much more risk and thus have to offer a higher interest to lure investors.
Municipal bonds and bonds issued by other entities directly or indirectly backed by the government are also low risk. Cities don’t default often and when the need arises, they can ask state or federal government to extend help in order to avoid bankruptcy.
One of the riskiest bonds are those issues by companies. However, there is a huge variety in the corporate bond market, which is understandable because the risk profile of a large established multinational conglomerate is drastically different from that of a small company. Credit rating agencies like S&P’s and Moody’s rate corporate bonds after assessing the risk that the company will default on its debt.
Similarly, these agencies also rate the risk of investments in different countries, which has a direct effect on the prices of bonds issued by that country. No bond investment should be made before checking the credit rating of the issuer.
Categorization Based on Redemption Options
The price of bonds is sensitive to the prevailing benchmark interest rates in the market. This translates into a risk for both the bond issuer and the investor. To offer protection from these risks, some bonds have built-in options for premature redemption.
If interest rates in the economy go down, the bond issuer would like to redeem the issue of bonds. This is because the entity would be paying a higher interest rate than it would have to if it made a new bond issue now. By having the option of calling the bonds for redemption if interest rates go down, the issuer can lower its lending costs. Bonds that provide this option to the issuer are called callable bonds. If the issuer wants to call the bonds, it has to provide an incentive to the bondholders in the form of a premium payment.
Callable bonds can be of two types – American callable bonds and European callable bonds. In case of American callable bonds, the issuer has the right to call the bonds for redemption at any time after a predetermined period known as the call protection period. In case of European callable bonds, the issuer can call for redemption only on some specific dates. In either case, the decision to call would be based on the difference between the coupon rate of the bond and the interest rate in the market. If the issuer realizes that it can lend at a lower rate then it will call the bonds for redemption.
The direct opposite of a callable bond is a puttable bond. Such a bond gives the redemption option to the investor instead of the issuer. If interest rates go up, the price of the bond could fall below its exercise par, in which case investors would like to redeem their bonds. They can then put their money in other investments to earn higher interest.
Another popular redemption option in bonds is to convert them into shares of the issuing company. Such bonds are referred to as convertible bonds and the number of shares that each bond can be converted to is determined before the issue. Of course, this option can be exercised only before the bond has matured and investors have been paid back the principal amount.
Categorization Based on Interest Payments
There are many ways in which interest can be paid on a bond. The simplest situation is where the coupon rate is fixed and regular payments are made in each period before the maturity of the bond. At the time of maturity, the par value of the bond is paid back along with the last interest payment. Such a bond is called a plain vanilla or a straight bond.
Another simple option is where the bond pays no periodic interest at all. These zero coupon bonds are sold at a significant discount and the accrued interest up to the time of maturity is paid back along with the face value of the bond when the bond matures.
Floaters are floating rate bonds are those in which the coupon rate is linked to an underlying benchmark interest rate, like the LIBOR (London Interbank Offered Rate) or a T-bill rate for a specific period. When the underlying interest rate changes, the coupon rate of the bond also changes accordingly. Of course, there could be many ways in which the coupon rate is linked to the underlying. For example, the coupon could always stay at 2% higher than LIBOR or 1.5% lower than it, or it could just remain equal to LIBOR at all times.
Another possibility is that the coupon could move in a direction opposite to the benchmark. Known as inverse floater, such a bond could have a coupon set at a certain percentage less the benchmark. For example, it could be 7% minus LIBOR. Note that for an inverse floater, the benchmark has to be a short term interest rate.
All these different coupon options add variety to the bond market so that both issuers and investors can choose a bond type that meets their financial goals.
Categorization Based on Place of Issue and Denomination Currency
Most bonds are issued in the same country where the issuer is based. Such bonds are issued in the local currency. But things start getting complicated when bonds are issued by foreign entities – both governments and companies. There are three main possibilities when a foreign entity issues bonds.
When the bond is issued in a foreign currency, it is referred to as a eurobond. The term can be misleading, as these bonds have nothing to do with either the Euro zone or the euro currency. For example, a bond issued in the US by a Japanese company and denominated in yens is also a kind of eurobond.
Another possibility is when the foreign company issues bonds in the currency of the country where the bond is being issued. For example, when a British company issues dollar denominated bonds in the US, they are referred to as foreign bonds.
The third kind of international bonds is where the foreign entity issues the bonds in its own currency (like in eurobonds), but this time the bond is also available in the country where it is based. When a British company issues pound denominated bonds both in the US and in Britain, they are referred to as global bonds.
Whenever you are investing in foreign denominated bonds, keep in mind that your returns will be subject to foreign exchange fluctuations. If you are holding yen denominated bonds, you will earn interest in yens, which you’ll have to convert into dollars. If yen falls against the dollar, your returns in dollar terms will fall as well.
Categorization Based on Priority of Payments
Another very important classification of bonds is on the basis of the payment priority that bond holders get in case the company defaults. In case of bankruptcies, a company’s assets are liquidated to pay off debtors. But in most situations, the assets are not sufficient to repay all the debtors. So during the liquidation process, who gets paid first becomes extremely important as if you are low on the payment priority order, you may not get paid at all.
Bonds that come high on the payment priority order are known as unsubordinated bonds. Bonds that are low on payment priority as known as subordinated bonds. Holders of subordinated bonds get paid only after holders of unsubordinated bonds are paid off.
The bond you want to invest in could have any combination of these categorizations. Almost all of these will affect the risk that the bond will carry and the return that you can earn on it. Consider your investment objectives carefully and then choose a bond that fits well in your broader financial plan.
Next Chapter: Pricing of Bonds
