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Bonds – Introduction- Characteristics of Bonds

Definition of a Bond and Associated Risks

I. Definition of a Bond

  • Basic Definition: A bond is essentially a loan.
  • Issuer: A company or government that needs to raise money can issue a bond, borrowing from the investing public.
  • Investor: An investor lends money in return for a promise of repayment on a fixed date and (usually) a series of interest payments.
  • Terminology: Bonds are often referred to as:
    • Loan stock
    • Debt
    • Fixed-interest securities (for those paying fixed income)
  • Key Distinguishing Feature: Unlike most loans, bonds are tradeable; investors can buy and sell them without needing to involve the original borrower.

II. Core Bond Characteristics (Example: 1.875% US Treasury bond 2041)

  • Coupon Rate: The stated interest rate on the bond (e.g., 1.875%).
  • Maturity Date: The fixed date on which the principal (initial loan amount) will be repaid (e.g., 2041).
  • Face Value (Par Value): The nominal amount the bond will be worth at maturity; often the amount used to calculate interest payments.
  • Issuer: Government or Corporate (e.g. US Treasury Bond is issued by the US Government).

III. Advantages of Owning Bonds

  • Regular and Certain Income: Fixed-interest bonds provide a predictable stream of income (coupon payments).
  • Fixed Maturity Date: Most bonds have a set date for principal repayment. (However, some have no redemption date, or repayment can be on one of multiple dates).
  • Range of Income Yields: Bonds offer a variety of income yields to suit different investor needs and tax situations.
  • Relative Security of Capital: Highly rated bonds are considered to have relatively secure capital, though not without risk.

IV. Disadvantages of Owning Bonds

  • Erosion by Inflation: The real value of fixed income is eroded by inflation (except for index-linked bonds).
  • Exposure to Risk: Bonds are not risk-free and carry several types of risk.

V. Risks Associated with Holding Bonds

  • General Risks:

    • Default Risk (Credit Risk): Risk that the issuer will fail to pay interest or repay the principal at maturity. This risk is higher with corporate bonds.
    • Price Risk (Market Risk): The risk that the market price of a bond will fluctuate due to changes in interest rates and other factors.

  • Historical Context:

    • Government bonds used to be considered nearly risk-free, having only price risk.
    • Recent events such as government bond market turmoil have highlighted default risk in government bonds.

  • Interest Rate Risk:

    • Inverse Relationship: There is an inverse relationship between interest rates and bond prices.
      • If interest rates increase, bond prices will decrease.
      • If interest rates decrease, bond prices will increase.
    • Impact: Changes in interest rates can have a significant impact on the value of bond holdings.

  • Bond Pricing:

    • Impact of Coupon Rate: As long as the interest being paid on a bond is near the interest rate available on the market, there is little risk that the resale price will be different to the purchase price. Bond price risks increase when the coupon rate of interest differs markedly from market rates.

  • Other Types of Risk:

    • Early Redemption (Call Risk):
      • Risk that the issuer may call (redeem) the bond early if it is callable.
    • Seniority Risk:
      • Risk that the issuer might take on new borrowing which has a higher claim on the companies assets than existing bondholders during liquidation.
    • Inflation Risk:
      • Risk that inflation rises unexpectedly, reducing the real value of the bond's coupon and redemption payments.
    • Liquidity Risk:
      • Risk that a bond is difficult to sell at a fair market price, which can be higher for some bonds compared to others.
    • Exchange Rate Risk:
      • Risk that adverse exchange rate movements will reduce or eliminate gains on bonds denominated in foreign currencies.

In Summary

Bonds are essentially tradeable loans that provide income and repayment of the principal. They have advantages like regular income and fixed maturities, but also have disadvantages like the erosion of value due to inflation and potential for significant risk. These include default risk, price risk, call risk, seniority risk, inflation risk, liquidity risk, and exchange rate risk. Investors should carefully consider these factors before investing in bonds.

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