Bonds


What are Bonds and why are They Important?

Bonds are one of the most important but misunderstood parts of the financial industry, partly because there are so many different types that serve different purposes. Bonds have received extra attention since the Financial Crisis in 2007 and 2008.  Bonds are loans issued primarily by governments and corporations.


What are Bonds and why are They Important?

Bonds are one of the most important but misunderstood parts of the financial industry, partly because there are so many different types that serve different purposes. Bonds have received extra attention since the Financial Crisis in 2007 and 2008.  Bonds are loans issued primarily by governments and corporations.

New bond issues occur in the primary market.  The bonds are purchased in an auction environment.  After the initial purchase of a bond, the bondholder can resell it in the secondary bond market.  The secondary bond market acts, in some ways, like the stock market.  People buy and sell bonds based on their expectations that they will go up or down in value. Also like stocks, bond values fluctuate relative to changes in market confidence and investor beliefs regarding several main variables including the likelihood of repayment on the bond by the issuer.

Bond Features: Yield, Coupon, Duration, Embedded Options

Bonds share some key features and common terminology including yield, coupon, duration, and embedded option.

Yield, expressed as in interest rate, varies inversely to a bond’s price.  It comes in several forms. Nominal yield is most a common measure.  This is calculate by dividing the interest received by the face value.  Yield to maturity is the return a bondholder can expect when holding a bond until its maturity date.

Coupon, also expressed as an interest rate, is a periodic payment of how much a bond returns to its holders in exchange for holding the bond.  Coupons are most often semi-annual, but can be annual or quarterly.

The U.S. Federal Reserve’s asset-purchasing program (quantitative easing) pushed interest rates to near zero.  Bond issues came with lower and lower interest rates.  Zero interest was a theoretical lower bound until some countries in Europe began issuing bonds with negative yields.  In effect, you are paying someone for the right to hold their debt.  Further, you will receive back less than you paid.

Duration

Duration is the bond’s price sensitivity to a change in interest rates.  This measure has a specific set of assumptions that need to hold for it to be a valid measure.  In the real world, violations of these assumptions are normal.

Embedded Options

Callable and putable bonds have a feature that allows a bond to be retired early.  A call option in a bond allows an issuer to have the bond returned to them so that they may reissue a bond with more favorable terms.  A putable bond has a feature that allows in investor to return the bond to the issuer so they are not committed to holding the bond until it matures or until they can sell it in the secondary market.

Corporate, Municipal, and Government Bonds

Of the several type of bonds commonly traded, the most common are corporate bonds, municipal bonds, and government bonds. Most large companies and government entities in the world use bonds as a way of raising necessary funds for business expansion, government projects, and more.

Corporations use the bond market instead of taking a loan out from a bank for a few reasons. Most importantly, many of these companies are larger than any one bank, so there is simply nowhere to go to get such a large loan. With bonds, a large company can borrow from many different creditors at once, who benefit from the spreading of risk. Thus, if a company wants to borrow $10 billion, it can borrow $1,000 from one million investors, limiting each investor’s relative risk in the event of a default.

Municipalities borrow money using bonds for very much the same reason, but creditors get an additional benefit from municipal bonds in that in many jurisdictions, they are tax exempt. This is an especially important part of the U.S. bond markets, since many retirees use municipal bonds as a low-risk income stream. Tax free returns on those investments mean more money in the investor’s pocket.  To offset the tax exemption, often these bonds offer a lower return than a taxable equivalent.

Finally, government bonds are a third, but extremely important category. They are also the largest market, by far. Almost every sovereign state in history has used some form of financing to support itself, and this has become routine and systematic through government bond markets. Creditors buy government bonds because they consider them the safest investments in the world (especially in the case of developed countries). As a result, demand for bonds issued by the United States, Germany, and Switzerland has peaked in the last few years, causing something called “negative yields,” in which demand for bonds actually pushes bond prices in excess of their potential yield.

Nevertheless, institutional investors favor the corporate, municipal, and government bonds because they fill the niche for a source of low-risk income as part of a large and diverse portfolio. Retirement funds, in particular, use these three bond types to provide low-risk, reliable income that they can use to pay to vested retirees. Other types of funds often use these bonds to receive a less volatile and more reliable steam of income than many stocks can provide.

Savings and TIPS

Retail investors more commonly gravitate towards other kinds of bonds known as savings bonds or Treasury Inflation-Protected Securities, or “TIPS”. The market sees both of these bonds as extremely low-risk ways of saving money for a fixed period of time. Like all bonds, they have a period in which they become due and in which the debtor pays back the principal in full. However, because of their relative safety, the rate of return for these types of bonds tends to be much lower than other, higher-risk bonds.

In most cases, savings, TIPS, and other government bonds represent the lowest risk form of bond investing, while municipal bonds will have slightly higher risks (and rates of return). Corporate bonds tend to be riskier still, but usually have the highest rate of return.

Target Rates, Growth, and Inflation

For the economist or other finance professional, government bonds have begun to serve an important, but incredibly complex function in financial and economic models. Government bonds tend to reflect inflation rates and help economists better understand the broader market’s expectation for future economic growth. Government bonds also tend to reflect expected future inflation. By looking at the yield of a government bond, economists can often predict how much economic growth and inflation the market expects by taking cues from investor behavior in the bond market.

In recent years, this caused an unusual phenomenon that was long thought impossible: negative yields on some bonds. As noted, a negative yield means that the bondholder (the creditor) is literally paying money to the bond issuer (the debtor). In other words, the creditor is paying the debtor for the privilege of lending money to it.

This is counterintuitive and difficult to understand from a common sense perspective. Yet, from a wealth management perspective it makes much more sense. As the “Great Recession” proved, banks can fail. While the federal government insures funds on deposit with banks, the amount protected is capped at $250,000. Wealthy investors may need to store larger sums than that, but want to protect it in the event of a bank failure. Thus, a bond may be an attractive alternative.

However, if a lot of large investors need to find low-risk instruments to store their wealth, they might create a lot of demand for that government’s debts. The result is an increase in bond prices, which causes yields to fall. With enough demand, those yields go negative. This has recently happened to short-term and medium-term bonds in Germany and Switzerland, and some analysts predict it could come to the United States.

Bonds Will Remain a Staple of Investor Portfolios

Bonds are an excellent, low-risk form of investing. Like any other form of investing, greater security often comes at the cost of higher returns, but the benefits of bond investing (steady, secure income, and low to moderate risk) make it a perpetual favorite of the financially savvy. Though plagued in recent years by reports of negative yields, bonds remain one of the safest ways to invest, making it a favorite of well-diversified investment funds, wealthy investors concerned about protecting their money from bank failures, and fixed-income retirees.

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