He’s famous for his cool moves, dangerous gadgets, and iconic cars. Well, that is James Bond. But if we talk about finance, what we refer to is a bond. Though not as flashy as Bond, many people still like and even seek recourse from bonds. Don’t want to risk too much? You turn to bonds. Want to balance portfolio risk? There is a bond. But what really are bonds? How do we earn from it? What are the risks in this security? We’ll answer these questions in this article, so get ready to take another step towards becoming a true Filipino investor!
What are Bonds?
Bonds are debt instruments involving the issuer and the holder of the bond. Basically, the bond issuer is a corporate or government borrower who issues or sells bonds in the market to raise money for their capital expenditures with the expectation that the benefit of whatever it is that they are raising money for will exceed the cost of borrowing. The bond investor purchases bonds and, thus, is owed, by the issuer (know more about this borrower-spender and lender-saver relationship in this article). How much does the issuer owe the investor? To put it simply, issuers are obligated to pay back the principal amount invested in the bond as well as interest payments at fixed dates. Investors usually earn from bonds by holding a bond for interest payments or by trading it in the bond market at a price higher than the price at which it is acquired.
Bonds are under a larger asset class known as fixed-income securities. These are investment securities that give its holders a regular source of income, through fixed interest payments or dividends, until maturity and the principal amount invested on maturity. Usually, companies and governments issue these instruments to borrow money from the public. The income from this is fixed and known in advance, thus, the reason why it’s called “fixed income.”
To further understand a bond, we will dissect it into its basic components, so make sure you keep reading!
Components of a Bond
A bond has different components. We see some of these in bond indentures — certificates that evidence a borrowing agreement between the issuer and the bondholders. Nowadays, traditional bond indentures are not that common as most bonds are electronically registered; thus, transfer of ownership happens electronically and so do payment of interest, making it more convenient for bondholders. However, be it evidenced by a paper or electronically, the components of bonds are mostly similar and these components are important in making bond investment decisions. These components and their descriptions are as follows:
- Face value (also called Principal or Par value) — The principal — does not run a school — rather, it’s the price of the bond when it is first issued and is also the worth of the bond upon maturity. Thus, a bondholder or bond investor is entitled to receive the face value at maturity, aside from the interest, assuming the issuer does not default or fail to pay this interest or principal. If there is a default, then you have every right to be disappointed.
- Coupon rate ( or Stated rate) — The coupon rate is the rate applied to the face value of a bond to determine the interest payments for every bond that a person holds. For example, if the bond has a face value of ₱1,000 and stated rate of 9%, and a bond investor holds 10 of such bonds, then each bond is entitled to receive annual interest of ₱90 which translates to a total interest payment of ₱900 for 10 bonds held. Why the name “coupon”? Well, traditional bonds have actual coupons (like stubs) attached to them. These are presented to banks on the indicated interest payment date so you can redeem your coupon (or interest) payment.
3. Price. The bond price is the amount paid by an investor to purchase a bond. Note that the face value of a bond will not always equal the price, mainly due to differences between stated rate and market rate. Always remember this since you’ll see price a lot in the subsequent parts of this article.
4. Issuance and Maturity date. The issuance date is the date when the bond was first sold in the primary market and is the start of the agreement between the issuer and bondholder. On the other hand, the maturity date is the last date for the issuer to pay or settle any unpaid obligation (mainly interest and principal) to the bondholder.
5. Tenor and Term to Maturity. The tenor is the length of time between the issuance date and the maturity. Interest payments are made throughout a bond’s tenor On the other hand, the term to maturity is the remaining time before the bond’s maturity. The longer a bond’s term to maturity, the more a bond is exposed to variable factors that may affect it, thus, a greater risk (wanna know if a certain risk level is suitable for you? Click here.)
How is Bond Price Set?
In making bond investment decisions, investors assess their bonds relative to the market. The most common factor affecting bonds are interest rates. Fundamentally, the two most important rates for bond investors are as follows:
- Bond’s coupon rate or stated rate. This is used to determine the annual interest payment of a bond. This interest rate is fixed, no matter what the circumstances are of the issuing company or of the economy. Recall our previous example. The 9%, which determined how much the bondholder will receive as interest payments, is our stated rate.
- Market interest rate (aka yield to maturity (YTM), yield, or effective interest rate). This is the prevailing interest rate of bonds in the market with virtually the same characteristics and risks as your bond in terms of its components other than coupon rate. In other words, it is the interest rate of other bonds similar to your bond. This is the actual rate of return of a bond assuming that the bondholder holds it until maturity. This interest rate changes over time depending on market conditions.
A bond’s price is the price at which it is traded at the bond market. This is the present value of the cash flows (i.e. interest and principal payments) of a bond using the market interest rate. Now, what is the relevance of the coupon rate and market interest rate on the price? For beginners, the interaction of these two interest rates influence the price at which bonds are traded. When we say bond trading, this is the process by which investors bid and ask prices in the bond market and eventually buy and sell bonds. The price of bonds is determined by the interaction of the bond sellers and buyers (aka supply and demand) and is hugely dependent on interest rates, causing it to sell at a price above, below, or equal to its face value.
When a bond trades above its face value, we say that there is a premium. This happens when the market interest rate is higher than the coupon rate of the bond. When a bond trades below its face value, there is a discount which indicates that the market discount rate is higher than the coupon rate. When the price is equal to the face value, we say that the bond trades at par since the market interest rate and coupon rate are equal.
Let’s say you are holding Bond A with a coupon rate of 5%. However, other bonds in the market with similar characteristics and risks as Bond A have a yield of 7%. Holding other things constant, if both bonds sell at the same price but Bond A will give lower interest payments, will a logical investor buy Bond A? Obviously, no. There are other bonds in the market that can give you higher interest payments than Bond A. Because of this, the demand for Bond A will decrease causing its price to decrease. Another intuitive approach to understand this is that Bond A will be at a discount to compensate for a lower interest rate. Why? At the same price, Bond A gives less benefits than Bond B since Bond B promises more interest payments in the future. How can Bond compete with the benefits of Bond B? To compete better, Bond A can be priced at a discount so that its holders will not only receive the benefit from the interest payments but also from the discounted price of the bond. In this way, Bond A will virtually have the same benefits as Bond B. Virtually, the present value of the future interest payment from Bond B is only equal to the sum of the present values of the savings from the discount and the future interest payments from Bond A. The same goes if Bond A has a 7% coupon rate while the market interest rate is 5%. Due to a higher interest rate, the demand for Bond A increases which, as a result, increases its price above par. The premium can also be interpreted as compensation for the higher interest rate that Bond A offers. The intuition for this premium is like an extra payment to enjoy higher interest payments in the future relative to other bonds that give lower future interest payments.
From this, we can say that in bond investing, your total income from a bond is not wholly determined by the interest payments — some of it is also determined by the price. The price is set through the interaction of the coupon rate and market interest rate. It is because of this that bonds are priced at a discount, premium or at par. After considering all future interest payments, discounts or premiums, and the market interest rate, bonds with similar characteristics will just have the similar rate of return since bonds will be discounted, or cheaper in terms of price, if they have a lower coupon rate relative to the market and those with higher coupon rates will be priced at a premium — at least in an efficient market.
Fixed income investments are considered safer investments than stocks since you get the face value of your investment at maturity plus a fixed interest payment throughout the bond’s tenor. However, this does not mean that bonds have no risks. Actually, the interest rate of a bond itself is a reflection of that risk and that this interest rate moves relative to that risk. To show their relationship, we say that risk is proportionate to interest rate. This means that investors will demand higher compensation or interest rate for taking the risk in investing in riskier assets and vice versa. For example, I am planning to buy bonds from Company X or Company Y. However, sources say that Company X has solvency issues. In this case, Company X is more risky. If I will buy bonds from Company X, I want more compensation, in the form of higher interest rates, for taking that risk.
Now that we know this, we must know what really are these risks. Well, bond risks are mainly divided into two: interest rate risk and default risk.
Interest rate risk
Interest rate risk is the probability of a decline in the price of an asset due to fluctuating market interest rate. For starters, the yield of a bond is inversely proportional to its price. Now, don’t be confused since the yield of a bond, market interest rate, effective interest rate and YTM is just one. Going back to the point, the price of a bond decreases if the yield increases and vice versa. This was demonstrated a while ago when we determined how a bond’s price is set. But what is the implication of a fluctuating market interest rate? This can mainly be explained through bond prices and the concept of opportunity cost. At any point in time, investors want the maximum returns for themselves. As such, when I buy a 10% bond at PHP 100 today, I want similar bonds to be issued in the future to have the same or lower interest rate since I know that the interest I’m receiving is higher than the market and that the bond I’m holding will hold just the same price or higher. However, if tomorrow, similar bonds are issued with a 15% interest rate, then I will feel that I just foregone or wasted the opportunity to buy the 15% bond. Also, people will just buy the 15% bond rather than the 10% bond. With less demand for the 10% bond, then the price of my bond will decrease. I don’t want this because if I need to sell the bond, I will have to sell it at a lower price than when I bought it — in short, a loss. This is why in a stable market, people are not so worried about opportunity cost and bond prices since they expect interest rates to just be around the same level as when they bought their bonds. However, in a market where interest rates fluctuate greatly, there is a higher probability that interest rates will increase. People are worried that their bond prices might decline or that if they buy now, they might miss the chance to buy a bond with higher interest rates tomorrow. This is why a market with fluctuating interest rates has higher interest rate risk than a stable one.
It is important to note that the sensitivity of a bond’s price to interest rate changes mainly depends on two main factors: term to maturity and coupon rate. Bonds with higher coupon rates relative to the market interest rate of similar bonds are less sensitive to interest rate fluctuations since there is more allowance for interest rate fluctuations. Also, the price of bonds with longer term to maturity are more sensitive to interest rate fluctuations since interest rate changes are more probable to occur in the long run. As a result, long term bonds usually carry higher interest rates to reflect this risk. This relationship between term to maturity and interest rate is usually shown through a yield curve. It is good to note that this relationship does not always hold. Pending recession, characterized by a general decline in economic output and activity, short-term interest rates are higher than long term interest rates because the short term is riskier due to the recession. Meanwhile, the long term is safer since investors expect that the economy will stabilize in the long term.
This type of risk is the probability that the bond issuer or borrower fails to make full or timely payments of interest and principal to the bondholder or investor. This is usually indicated by the past dealings of the issuer and by bond ratings. Regulatory agencies usually require issuers to get their bonds rated by independent credit rating agencies like Fitch Ratings, Moody’s Investors Services, Standard & Poor’s, and the Philippine Rating Services Corp. (PhilRating) so that investors will have a reliable basis for making investment decisions.
The relationship of the default risk and interest rate of a bond is simple. Higher default risk entails higher the interest rate and vice versa. Why? Assume that we have two similar bonds, Bond A and Bond B. Bond A has higher default risk than Bond B. Rational investors will pick Bond B. As such, in order for Bond A to fare well in the bond market, it should have been issued at a higher rate to compensate for its higher default risk.
How to Invest in a Bond?
Investing in a bond usually requires more hassle than investing in stocks since buying and selling stocks can now be done online and at a lower minimum denomination. Typically, a bond investor needs to go to a local bank to buy a bond. The typical minimum amount to invest in a bond is P50,000. However, retail treasury bonds (RTBs) are already available which have a lower minimum investment at P5,000. Recently, Bonds.ph, a mobile application for buying bonds, allowed investors to purchase RTBs online. This makes bond investing more convenient and accessible for Filipinos — you just register, cash-in, and invest. However, as of now, the app is only available for the primary issuance of RTBs. As such, you cannot use it to trade bonds. Another way is to invest in a bond fund — a portfolio managed by professionals who buy, sell or hold different fixed income securities. This option is for those who don’t have time to manage their bond investments since a professional will handle this for you. However, the management fee is the con. This is an important consideration since this lowers your total return from an investment.
Hello! Are you still reading this? If yes, well a big clap for reaching this point. Now, we bet you already know what a bond is and how it works. You also know some of the common ways to invest in bonds. That’s why if you have some money laying around, without any productive use and not reserved for another purpose, maybe you can get that cash and go buy bonds, ’cause why not if it can give you more gains than what unproductive cash gives you (which is zero and you’re at a loss if that happens!)
So, you now know the basics of stocks (and how to analyze them) and the basics of bond investing. So here’s an idea, why not invest in both? There is an easy and beginner-friendly way to do this — through mutual funds.
Watch out for our article on mutual funds next week. Also, don’t forget to visit UP JFA’s Pisopedia to learn more about finance-related stuff. See ya!