Although bonds are a dominating force in the global investment space, the average consumer often has very little idea as to what they actually are, or how they work.
Whilst we will provide you with a comprehensive breakdown in our guide, to summarize in one sentence:
Bonds are a way for corporations or governments to raise money and in return, investors receive regular interest payments until the loan is repaid full at the end of the term.
Due to the sheer complexities of bonds, there is no one-size-fits-all approach. This is because the underlying terms will vary depending on the agreement made, the health of the institution distributing the loans and the length of the loan itself.
If you are to get one key takeaway from our ‘What are Bonds’ guide, it should be that bonds are a mechanism for large-scale organizations or governments to raise capital in the open marketplace.
Within our comprehensive guide, we’ll explain what bonds are, how they work, who generally issues them and how interest rates have a direct correlation to the overall health of the institution issuing them.
What are Bonds and how do They Work?
In a nutshell, bonds are a form of loan that are utilized by major organizations. Whilst this includes large institutions such as banks, pharmaceuticals, tobacco firms and oil companies, in effect, bonds can be issued by corporations from any industry. It is also important to note that bonds are not exclusive to the private sector. On the contrary, virtually every government in the world issues bonds on the public marketplace, as a way to raise capital.
To illustrate the size of the global bonds market, it is believed that the entire arena is now worth more than $100 trillion. To put this in to perspective, the S&P Dow Jones is worth approximately $64 trillion.
Moreover, data industry firm SIFMA claim that whilst daily trading volumes in the S&P amounts to $200 billion, bonds more than triple this figure at $700 billion. As such, the bonds industry is of significant size.
When large institutions need to raise capital, bonds are often utilized because of the substantial figures involved. In other words, as the corporation or government need to borrow so much money, a loan issued by a single provider would not be possible. As a result, bonds are essentially multiple loans provided by multiple stakeholders, packaged into a single bond agreement.
A United States Savings Bond from 1944, Source
Although we will explain this in more detail further down, when bonds are issued, they generally have a fixed repayment date, otherwise known as the maturity date. Between the time that the bonds are issued and the maturity date arrives, the corporation or government that issued the bonds will make regular interest payments to its investors, or bond holders.
When the bond maturity date occurs, the institution will then repay the borrowed amount in full. In layman terms, this is effectively an interest-only payment until the maturity date, at which point the total amount is settled in full. It is also important to note that the bond holder has the right to trade the underlying investment on the open marketplace.
As a result, the actual value of the bond itself will fluctuate, depending on a range of conditions, such as the financial health of the bond issuer or external economic factors. Secondary markets that allow investors to buy, sell and trade bond agreements are generally facilitated on publicly traded exchanges, although private trading can also occur too.
How are the Value of Bonds Calculated?
When it comes to the price of bonds, or the amount of interest that investors can earn, the underlying mechanisms operate in a very similar fashion to traditional loans. For example, think about obtaining a loan with a conventional high street bank.
The interest-rate structure of a loan, or simply interest yield, is not only determined on a bank-by-bank basis, but on a person-by-person basis too. What we mean by this is that the interest rate offered to you will potentially depend on your credit worthiness. Whilst those in good financial health will generally be in receipt of lower interest payments, high rates are often charged to those that sit at the opposite end of the spectrum.
This exactly how the structure of bond agreements work. For example, if we were to look at the interest rate payments currently being offered by governmental institutions, we can see that there is a great disparity in the yield of each bond agreement based on the economic health of the nation in question.
At the time of writing, the UK government are issuing bonds with a 10-year maturity date at an interest rate of just 1.3%. At the other end of the risk spectrum, the likes of Brazil and Mexico are offering investors 9.09% and 8.16% respectively. As such, the market value attributable to a bond holder is based on the strengths and weaknesses of the underlying economy. This also rings true for the corporation bond space.
We should also note that the interest yield rates are also determined by the length of the term. As the length of the maturity date decreases, as does the yield rate on offer for investors. For example, whilst 20-year bonds issued by Italy are currently paying a yield of 3.47%, 1-year terms pay just 0.18%.
The key reason for this is that generally speaking, the longer the term of the bond agreement, the higher the risk, not least because external economic factors can have a detrimental effect on the underlying value of the agreement.
So now that you have a better understanding of how bonds work, in the next section of our guide we will explore whether or not bond investments are safe.
Are Bond Investments Safe?
Whilst there is no hard and fast rule when differentiating risk levels between corporate and government bonds, many would argue that in reality, the latter is somewhat safer from default than the former. However, one only needs to look at the likes of Venezuela to understand that bond investments are never a 100% sure-fire protection against risk.
In fact, the hyperinflation ridden South American nation has defaulted on multiple occasions, rendering the bonds virtually worthless.
The ability to lose money from a bond investment far exceeds just defaults. For example, if you invested in 20-year government bonds but decided to sell the bonds mid-way through the term to free-up capital, there is no guarantee that you will get more than what you paid.
On the other hand, if economic forces dictate that the issuer faces a higher risk-level than was in place at the time of purchase, then it is likely that you will need to sell them for less than you invested.
Outside of the aforementioned concerns, you also need to factor in other economic factors such as inflation. In a nutshell, there is a direct correlation between central bank interest rates and bond prices dictated on the secondary markets.
The way to think about it is if you invested £10,000 in to bonds at a yield of 5%, but then during the term of the bond interest rates rose to 10%, you would need to sell the bonds for less. This is because third party buyers would obviously want 10% interest, as opposed to the 5% your bond facilitates.
All in, bonds are generally seen as one of the safest mechanisms to preserve wealth, however each bond agreement will have its own ‘Risk vs Reward’ structure. To clarify, whilst purchasing government bonds from the U.S. over Brazil will yield significantly lower returns, the risk of such as an investment is also substantially lower.
So now that you know the underlying risks associated with bond investments, in the final part of our guide we are going to discuss how you can make an investment.
How to Invest in Bonds
Whilst purchasing both governmental and corporate bonds is entirely feasible for an everyday investor, it is important to note that the underlying mechanisms are significantly more complex than buying traditional stocks and shares. One of the key reasons for this is that you need to have a firm understanding of the individual specificities that will affect the future value of your investment.
Nevertheless, if you do decide to invest in bonds, then this can be facilitated in a number of ways. If you are looking to invest in corporate bonds, then this will usually be though a third party broker if you are purchasing newly issued bonds. However, much of the bonds sold in the primary market are reserved for the institutional space, such as banks or investment houses.
This is similar to the traditional IPO (Initial Public Offering) arena, where everyday investors rarely get a look in until the stocks hit the open marketplace.
On the other hand, if the bonds are already in the open marketplace, then trading is usually initiated through an OTC (Over-the-Counter) provider. In order to access the OTC bond market, you’ll still likely need to go through a broker.
When it comes to buying government bonds, this can also be a somewhat tricky exercise. The U.S. Treasury have made is super-easy to purchase bonds directly from their official website, although this is reserved for U.S. citizens. Alternatively, non U.S.citizens can still purchase government bonds, but will instead need to go through a broker. This also rings true for the vast majority of other jurisdictions, who only sell their bonds to accredited third party brokers.