Bonds are a type of debt security. Debt securities are financial instruments that represent the obligations of a borrower to a lender. So really, bonds are effectively IOUs. When you buy a bond, you are lending your money. You can invest in bonds and other debt securities just like you can cryptocurrencies such as bitcoin. Bonds are very different to other types of investments like stocks and real estate. Below, we at Collective Shift tell you what you need to know about bonds.
Understanding Bonds
We’ve already established that bonds are debt securities. There are many other types of debt securities out there. Asset-backed securities (ASBs) and commercial paper are two other types. Bonds are by far the most common type of debt security. So we’ll focus just on them for the sake of this resource. As we touched on above, you’ll understand bonds in no time if you think of them as an IOU. And just like IOUs, bonds simply don’t work unless there is a borrower and lender involved. With bonds, the borrower is the entity which issues the bond, and the lender is the entity which buys the bond with money.
Borrower is the bond issuer
Almost always, the entity which issues a bond is either a government or company. They do this to raise money. With this money, governments can fund capital investments in public infrastructure such as schools and hospitals. As for companies, they can do things like boost operating cash flow and invest in new areas of business.
Lender is the bond holder
You might be thinking, “why would I buy a bond?” It’s a good question to ask. After all, you’re effectively lending your money when you buy a bond. For doing that, you deserve compensation. With bonds, this compensation comes in the form of regular interest payments known as ‘coupon payments’. If you hold the bond at the time of maturity, you’ll get back the amount that was paid for the bond at the time it was issued. (This amount is known as the ‘face value’, ‘par value’ or ‘principal’.)
Why Do People Invest in Bonds?
There are several reasons why you might invest in bonds. Let’s go over some of the main reasons.
- Portfolio diversification. Bonds are often used to help diversify a portfolio. Maintaining asset diversification within a portfolio can help protect your investment returns over the long term. That’s because investing in bonds is typically less risky than investing in growth assets like shares or real estate.
- Stable income stream. Coupon payments happen at regular intervals, such as every six months. Because of this, holding bonds can provide you with a stable and predictable income stream. This is particularly appealing for retirees.
Why Bond Prices Change
There are lots of factors that can impact the market value of a bond. This varies a lot between different types of bonds. (So, when we say ‘bonds’, just assume we’re talking about government bonds.) Before getting into what causes bond market values to move, it’s worth distinguishing between bond prices and yields. Prices and yields on bonds move in opposite directions. When one goes up, the other goes down. Now you know that, let’s get into some reasons why the market value of a bond changes.
Interest rates
Interest rate movements have arguably the biggest impact on a bond’s market value. When a central bank announces that interest rates are changing, the value of bonds move in the opposite direction. Let’s say an Australian government bond has a coupon rate of 5 per cent and a face value of $100. One day, the Reserve Bank of Australia comes out and says that they are raising the interest rate to 7 per cent. The RBA’s decision to increase rates will cause the market value of the bond to fall. That’s because the bond’s 5-per-cent coupon rate won’t look as attractive to investors.
State of the economy
Generally speaking, the level of demand for bonds will vary depending on how healthy the economy is. During times when an economy is growing at a healthy rate, investors will typically increase their exposure to growth assets. In such an environment, demand for bonds is relatively weak. This puts downward pressure on bond prices. Bond prices will usually rise as the outlook on economic conditions gets worse. That’s because investors will be allocating a greater percentage of their funds to bonds and other defensive assets.
How Do You Buy Bonds?
You can buy bonds on either the primary market or secondary market. Buying a bond on the primary market means you are buying it directly from the bond issuer. Corporate bonds are not usually available to the public on primary markets. For the vast majority of people, they buy and sell bonds on the secondary market. The bonds that are trading on secondary markets are those that have been issued but are yet to reach maturity. When you buy a bond on the secondary market, you are buying it from another investor and not from the bond issuer.
You can access the secondary markets through securities exchanges. In Australia, the leading securities exchange is the Australian Securities Exchange (ASX). Like shares, government bonds trade on the ASX using security codes. If you want to invest in bonds, an easy and relatively cheap way to invest in bonds is through exchange-traded funds (ETFs) or exchange-traded bonds (XTBs/ETBs). When you invest in an ETF or XTB/ETB, you don’t actually get legal ownership of the bond. You do get all the economic benefits of holding it, however. One place you can buy and sell bonds ETFs is eToro, the world’s leading social trading and investing platform. The process of doing this is almost identical to buying and selling stocks on eToro.
Build Your Bond Knowledge
As you’ve seen in this resource, there are many terms that are specific to bonds. For your convenience, we’ve put them all in one place below.
- Compound frequency
- The frequency with which a bond pays interest. Coupon frequencies are almost always quarterly, bi-annually or annually.
- Coupon rate
- The annual interest paid to the bond holder.
- Discount
- On the secondary markets, bonds may trade at a discount. This means a bond’s market value is below its face value. For example, if a bond with a face value of $1,000 is trading at $850, it is said to be trading at a $150 discount.
- Face value
- The dollar amount that the bond issuer borrows. This is repaid to the lender at maturity. (Remember, ‘face value’ means the same thing as ‘par value’ and ‘principal’.)
- Maturity
- The maturity of a bond is the length of time until the bond comes due. When this happens, the bond holder receives the face value.
- Maturity date
- The maturity date is the date on which a bond holder can expect to have their principal repaid by the bond issuer.
- Premium
- On the secondary markets, bonds may trade at a premium. This means a bond’s market value is above its face value. For example, if a bond with a face value of $1,000 is trading at $1,070, it is said to be trading at a $70 premium.
- Yield curve
- The yield curve is a line that maps the yields on comparable bonds of different maturities. For example, bonds of different maturities issued by the Australian government are often shown on a yield curve.
- Yield to maturity (YTM)
- A calculated estimate of the total amount of interest income a bond will yield until it hits maturity. This figure is usually expressed as an annualised rate of return. YTM is the most important factor for the majority of bond investors.