What is a bond?
A bond is a contract in which it is precisely regulated that several investors provide the issuer with a certain amount of capital for an agreed term and interest rate. The investor is a creditor of the issuer and has the right to interest and repayment of the capital invested. Therefore, a creditor and a debtor are facing each other. The investor can either hold the bond until repayment (redemption) or resell it beforehand.
The sale of securities at the time of issue is defined as the primary market. In contrast, trading on the exchange operating company's markets or over-the-counter trading is the secondary market.
Why may bonds be a useful instrument?
Bonds pay interest agreed in advance, usually higher than on a savings account. The interest rate can be fixed or vary over the entire term (floating-rate debt securities = floaters). You can sell bonds at any time, but there is a specific price risk. A crucial issue for investors is the issuer's creditworthiness, i.e., its ability to meet all financial obligations during the bond term.
What types of bonds exist?
The following criteria classify bonds:
- Interest rate structure and maturity: Fixed-rate ("straight bond") and floating-rate ("floater") bonds, zero-coupon bonds (discount bond)
- Securitized rights: Convertible bonds, bonds with warrants, income bonds
- The currency of issue and place of issue: Dual currency bonds, mixed currency bonds, domestic bonds, foreign bonds
- Type of security: Bonds backed by a cover pool or public guarantees (funded/mortgage-backed securities), unfunded bonds, subordinated bonds
How to characterize a bond?
Most bonds have predefined terms. At the beginning of the period, investors provide the issuer with capital by purchasing the bond or (as it is also called) subscribing to the bond. During the period, interest is paid on the bond, and eventually, the bond is repaid (redeemed).
- The investor's interest payment takes place once a year for most bonds (= annual coupon date). Some bonds also have a semi-annual or quarterly interest payment (USA).
- The denomination of a bond refers to the smallest possible unit that can be traded. For public bonds, the denomination is usually EUR 100, EUR 500, or EUR 1,000; for offerings to institutional investors, the denomination is often EUR 50,000 or above. The sum of all pieces (denomination x pieces issued) denotes the total nominal.
- The issue price, redemption price, stock exchange price, and coupon are expressed as a percentage of the nominal value. For example, one bond unit with a nominal value of EUR 1,000 corresponds to 100 percent. An issue price of 101 means that one unit costs EUR 1,010 (= 101 percent of 1,000). The issue price and the redemption price can be precisely equal to the nominal value (= par), below the nominal value (= below par), or above the nominal value (= above par). A price below par is also referred to as a discount (= disagio), while a price above par is referred to as a premium (= agio).
Who issues bonds?
The most widely traded bonds are so-called government bonds (bonds issued by public authorities). Credit institutions issue bank bonds, which provide the capital raised to borrowers. Corporate bonds are becoming increasingly popular as a financing alternative for companies. The main advantage for companies is that capital raised by bonds does not burden existing credit lines. Meaning that the capital raised is not repayable until the end of the term, and the company does not need to emit further shares.
What returns and risks to expect?
With a bond, investors have two types of return sources: interest payments in the form of ongoing coupon payments and price fluctuations. Generally, however, the interest paid on the bond is the primary focus, as it accounts for the majority of the return.
Bonds have various risks, depending on the form they are structured. Since bonds generally have a fixed interest rate, which usually represents the central part of the return, they are typically considered safer than equity securities.
In general, the better an issuer's credit rating, the safer the bond and the lower the probability of default. Issuers with a higher probability of default must offer a higher interest rate (a risk premium) for new bonds in order to find investors for their bonds. Creditworthiness is determined by a so-called rating, which rating agencies assign.
The following risks can be distinguished for bonds:
- Price risk (= risk of interest rate changes)
- Issuer credit risk
- Currency risk (only for foreign currency bonds)
- Liquidity risk
- Termination risk
The risk of price losses and the opportunity for price gains arise from changes in the market interest rate level. If the market interest rate level rises, the prices of old (i.e., already issued) bonds fall; if the market interest rate level drops, senior bonds' prices increase. All bonds exhibit price fluctuations. However, as the bonds are redeemed at par, these fluctuations are of no further significance for investors who hold the bonds to maturity.
Issuer credit risk
Credit risk is the risk that an issuer will be able to repay only part of the capital made available to it (e.g., in the form of bonds issued) or not at all. Credit risk (also known as creditworthiness risk) reflects the quality or creditworthiness of a debtor.
Bonds denominated in a foreign currency (e.g., U.S. dollar or Swiss franc bonds) may be subject to risks or opportunities due to fluctuations in the foreign currency's exchange rate against the euro. If one owns a U.S. dollar bond whose interest is paid in U.S. dollars, then a decline in the dollar may reduce the interest credited in euros. There may also be a loss on the bond's redemption if the dollar exchange rate is lower at the time of redemption than when the bond was purchased (since you get fewer euros for the same amount of dollars). Otherwise, however, currency gains may occur.
Liquidity risk refers to the obligation of not being able to sell your bond to other investors if you need money before maturity. To minimize liquidity risk, it is advisable to purchase bonds already placed and have a high issue volume.
Many issuers grant themselves an early termination option in the bond terms and conditions to reduce the risk of permanently high-interest payments. Terminated amounts may only be reinvested at a then prevailing lower interest rate.
Governments and companies issue bonds with fixed interest payments to raise money on the capital markets. Therefore, anyone who buys a bond gives the issuer a loan. The spectrum of bonds is vast: There are very safe versions and highly risky ones. You can buy bonds individually or in the form of mutual funds.
These bond funds spread the risk over many individual securities but charge annual management fees. Bonds currently pay very low-interest rates, and decent returns are only possible if interest rates or price levels fall.