The financial services industry offers a wide range of products and services to those with capital to invest. Assets are items that have value, and include real assets and financial assets. Real assets are generally tangible possessions, such as property, production equipment and inventory, and financial assets are instruments such as equities and bonds. Each asset class has different investment characteristics, which you must know, before you can assess their investment suitability.
Investing in Bonds
When a large company or government needs to borrow money, it usually does so through the financial markets. A bond is a loan made from the bondholder to the bond issuer.The company or government issues securities that are generically called debt securities, or bonds. Bonds help finance new operations and may keep a company solvent. Bonds are a written promise to pay a specific amount at some date in time with an interest portion called a coupon. This name coupon came about because bonds were kept in a folder with tear off sections which the bond holder would present for a payment to the bond issuer.
Bonds are also used bond organizations that can’t issue stock or receive bank loans like governments, states, and school districts. Each bond is issued at its par value. Par value (also known as par, nominal value or face value) refers to the amount at which a security is issued or can be redeemed. Par value is important for a bond or fixed-income instrument because it determines its maturity value and allows us to do some calculations which tell us how much to pay for the bond at the present time.
When the investor purchases the debt security they are lending money to the issuer. The investor needs a reward (cost of money or return) for the risk they are taking in lending this money. The rewards is given when the issuer promises to make predetermined payments, usually on a regular basis (usually every quarter or twice a year), for the future, which may consist of interest and a capital sum at the end of the bond’s life.
Bonds vary considerably due to these interest payments. When a bond is issued a number of factors are taken into account. These factors include the trustworthiness of the issuer which is normally done via a credit rating agency. The most common credit rating agencies are Moody’s, Standard & Poor’s (S&P) and Fitch Group. S&P and Moody’s are based in the US, while Fitch is dual-headquartered in New York City and London. A rating agency assesses financial strength of companies and government entities and their ability to meet principal and interest payments on their debts. Other factors are the prevailing interest rates and the length of time the money will be invested in the bond.
To ensure that all the parties to the transaction understand their obligations, a legal contract is entered into between the bond issuer and the bondholders. The legal contract describes the key features of the bond. In the event that the issuer does not meet the contractual obligations, the bondholders typically have legal recourse.
The bond has three features described in the contract.
1. The Par / Principal Value or amount that will be paid by the issuer to the bondholders at maturity to retire the bonds.
2. The Coupon Rate or promised interest rate on the bond. Coupon rates are the payments the annual interest owed to bondholders.
3. A maturity date which is the date at which the bond matures and the capital is repaid to the bond holder.
Why are bonds so complex?
A bond will base the interest rate on the par value. This means if you buy a bond of R 100 and have a coupon rate of 6%- you would expect a payment per year of R 6 or 6% of the par or face value. In other words you would pay R 100 now to have a stream of R 6 per year until the bond matures.
However if the interest rate in a country goes up to 10%, the investor will want to sell the bond as 6% is lower than the 10% return he can get on his money now. No one wants to have R 6 when they could be getting R10 for the same amount of money. The reverse is true if the interest rate in the country falls down to 2%, then the price of the R 100 bond will go up as the interest rate is 4% higher than an investor can get in another investment. That’s R 4 more than you would get for your R 100. The bond price (market price) varies once it is issued due to the interest rates and the ratings or perceived ability of the issuer to pay back the money at maturity. As a result bond prices are complicated to work out, unless you enjoy maths. Even if you enjoy maths, bond prices are very difficult to fathom and the reason is not all bonds are created equal.
Bonds also have a host of other features attached with we call covenants. These are features that make a bond more attractive to an investor than a comparable bond from another company. The range of bonds is vast. You can get inflation linked bonds, called floating rate bonds, where the coupon price matches the inflation rate. Bonds that have pledged assets to cover the bond issue, in case of default and zero rate bonds that pay no coupons but will give a higher par value than the purchase value. You get bonds that the issuer can recall at will called callable bonds and puttable bonds where the purchaser can ask for their money back at any time subject to certain conditions. You even get bonds that can be converted into shares of a company. As you can imagine this makes working a bond price out to ensure you pay a fair price for it, quite challenging.
Remember the bond contract gives bondholders the right to take legal action if the issuer fails to make the promised payments or fails to satisfy other terms specified in the contract. For example if the bond issuer fails to make the promised payments (which is referred to as default) the bond holder has legal recourse to recover the promised payments. However what happens if the bond issuer goes into liquidation?
When a company is liquidated, assets are distributed following a priority of claims, or seniority ranking of the creditors. This priority of claims can affect the amount that a bond holder receives upon liquidation. It means the lower limit of what a bond holder in a liquidated company will receive is not fixed. However the upper limit is strictly limited. The par (face) value of a bond plus missed interest payments represents the maximum amount a bondholder is entitled to receive upon liquidation of a company, assuming there are sufficient assets to cover the claim. In liquidation you will hear this par value called the principle amount. A variety opf bond gives the person holding the bond preference in a liquidation. In other words the bond holder has more rights than an ordinary creditor.
What are government bonds or gilts?
Most governments issue bonds when their tax receipts are less than their expenses. In other words, they need to raise funds either to cover a deficit or to fund specific projects. Government issued bonds, or sovereign bonds, on paper that had a gilt edge. Gilt is a gold coloured substance. This is why we call government bonds gilts. Today there is no gilt edging or paper issued by the government, you would simply get a statement on a printer.
Bonds issued by reputable governments are considered the most secure in the world, although this does not mean that they are risk-free! These governments are acutely aware of the need to maintain a high reputation for paying their debt on time and are able to print more money, or raise taxes, to ensure that they have the means to pay the bond holders.
Pensions and Bonds
Bonds are used to help spread the risk in people’s pension investments as they get closer to retirement. Insurers need to invest in these bonds so they can make sure you get a pension (annuity) in future years. Long-term bonds are used where people plan to buy an annuity with their pension when they retire, because annuity rates are linked to the price of these bonds. These bonds give security to a pension portfolio providing they are of a good quality and the issuer will be able to meet the obligations of paying the coupon (interest) and buying the bond back at maturity. To protect the people who have invested in the insurance product or pension, reputable governments have strict (prudential) requirements on which bonds a pension product can use. Prudential requirements are considered to be aligned with the judgement that a sensible (prudent) person would use. This is where credit ratings agencies have the ultimate say on how a country or company is rated and if the pensions or retirement funds can use those bonds to invest.
Each credit rating agency has its own scale, ranging from AAA through to C. A C rating is used when indicating imminent default. Most pensions cannot invest in bonds lower than a BBB rating. Bonds with a rating of BBB or above are considered to be investment grade, while those with a rating below this are considered to be high yield but risky.
Bonds are less risky than equities as a rule, but they are definitely not risk free. The best way to invest in bonds is through a fund scheme, such as collective investment schemes, unit trusts or mutual bonds. This way the investor gets access to a range of bonds instead of being exposed to a single bond.