ABC Financials issues $400 Million of a 10 per cent five-year bullet bond at par ($100). This bond will pay interest semi-annually until maturity and is rated BB+ by international rating agency Standard & Poor’s (S&P). John Brown buys $10,000 when the bond is issued and will receive $500 (10,000*10%/2) each October and April for the duration. At the end of five years, ABC Financials will repay its $10,000.

A bond or note is a debt instrument in which investors lend companies, governments or their agencies money, with the expectation of receiving interest and the return of their principal on or before maturity. This is called purchasing a bond. There is a misconception that bonds are risk-free; this is an incomplete notion, and investors need a more fulsome understanding of these assets if they are to invest in them from an informed position.

Investors can buy bonds on the primary market (at issuance) or on the secondary market (where securities trade after issuance). In our example, Mr. Brown purchased the bond in the primary market. If he wishes to get back his principal before the bond matures, he will need to sell his holdings in the secondary market. When trading global bonds, issues with a volume of US$400 million or more tend to be liquid. ABC Financials’ bond issuance is therefore considered to be liquid, and Mr. Brown should have no problems selling in the secondary market as liquid bonds tend to trade daily and a bid (buy) and ask (sell) price is always available. The price at which he will be able to sell his bonds will be market determined and may be higher or lower than the price at which he purchased.

The Term Sheet of a bond is an important tool. It dictates the conditions of the bond. Information on the Term Sheet includes inter alia the maturity date, coupon rate, coupon frequency, bond rating, embedded features, and any covenants.

The primary maturity types are:

• A bullet or plain vanilla bond is one that fully repays principal at maturity, such as the one issued by ABC Financials.
• Had ABC Financials issued an amortizing bond which repays the principal over the life of the bond, they would have a more even cash outflow over the tenor of the bond and would avoid the large payment at the end.
• A sinking bond is like an amortizing bond, but instead of making the interim principal payments to the bondholders, it makes payments at specific coupon dates to a sinkable fund which the issuer can then use over time to retire portions of the bond.

ABC Financials’ bond’s tenor of 5 years is considered to be medium-term. Typically, the longer the tenor is, the higher the level of associated risk. There is an inverse relationship between risk and reward, the coupon in this case. The level of risk an investor is willing to tolerate will dictate the effective yield they can receive on a bond.

The rating is a way to measure the creditworthiness or riskiness of the security. The rating is important as it helps to gauge the ability to repay the outstanding debt. Locally issued bonds may not be rated but most global issues are. At BB+, ABC Financials’ bonds are considered non-investment grade, informally referred to as “junk” and may be more suited to moderate or aggressive investors. Bond ratings range from investment grade to junk. In an ideal world, investors will get back their principal, but the reality is that default is a risk when investing in bonds. As such, investors should assess issues prior to investing and throughout the term of the investment. Based on the current market climate, a conservative investor will not be able to purchase a bond maturing in 1 year at a 10% yield. Issues below investment grade tend to offer a higher yield, given their higher associated risk.

US Treasuries are bonds that are typically deemed “safe haven” because they are backed by the full faith of the US Government, rated AA. As a result of their rating, these bonds are often considered to be risk-free assets.

Embedded features may include a call or put option. The issuer has the right to buy back callable bonds at a specific date at a pre-defined price, prior to maturity while investors can sell puttable bonds back to the issuer prior to maturity.

The bond covenant is a legal document to protect both parties. Negative covenants prevent the issuer from carrying out certain activities while Affirmative covenants require the issuer to meet certain specifications.

A company’s or country’s performance and outlook will affect its bond’s market price that will result in capital gains or losses. While some investors practice a buy and hold approach to investing, it is good to rebalance your portfolio as the environment changes to get the most over the investment period. This can be done with the help of an Investment Advisor. 

With every investment, there is some level of risk. The bond market affords investors periodic cashflow by way of coupon payments and diversification of their investment portfolios. Given the vast number of fixed income securities, there is a note that will suit every investor.

Sources

Investopedia, Wolf Street, IMF