Investors are generally familiar with equities and many have had the opportunity to hold equity positions in various public listed companies. Share ownership is thus well understood. However, this may not be the case when it comes to investing in fixed income assets.
A fixed income security is defined by Investopedia as ‘an investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. The most common type of fixed income security is a bond issued by either the government or a corporation.
What is a bond?
As defined by Merriam Webster, a bond is ‘an official document in which a government or company promises to pay back an amount of money that it has borrowed and to pay interest for the borrowed money’.
Provided that the investor holds the bond to maturity, part of the returns achieved on the bond depends on the interest or coupons paid by the issuer.
How does a bond work?
When you purchase a bond from the government or a corporation, you are essentially lending money to the borrowing institution, also known as the issuer. In return for the loan, the issuer agrees to repay the loan principal or face value at a given date in the future. The date at which to loan is to be repaid is the maturity date. In the meantime, the issuer agrees to pay a given amount of interest known as the coupon. Most of the time, the coupon is paid out semi-annually.
Coupon vs Yield
Investors may hear these two terms bandied around by finance professionals but may be somewhat unclear about the nuances inherent in the concepts of coupon and yield.
Coupon refers to how much the bond pays when it is first issued. Since most bonds are issued at par or face-value, the coupon corresponds to the returns the investor would enjoy if he were to subscribe to a new bond issue. For example, if the bond has a face value of $1000 and a coupon rate of 3%, the investor expect to receive $30 every year, or $15 every half year.
The yield corresponds to the total return achieved by the bond. After the bond is issued, it begins trading in the open market. This means that the price would naturally fluctuate every trading day, depending on demand and supply.
To the concept of yield, it would be useful to study an example. Assuming that the bond has a face-value of $1000 and is issued at the same price. The bond matures in one year’s time. As it is traded in the marketplace, the lack of demand causes the price to fall to $800. At this level, an investor feels that the bond is under-priced and makes a purchase at $800.
Throughout the course of the year, the price of the bond may vary. However when the bond matures, the investor receives $1000 or the face value, regardless of the purchase price. The investor also receives the coupons of 3% linked to the bond over the entire tenure (in this case one year).
If we recall that the investor only paid $800 for the bond but received $1000, we must infer that the total return is constituted by the ‘capital gain’ of $200 and the coupon payments, which bring the total return above 3%. Thus, if the bond is held to maturity, the total return is known as yield to maturity.
Another related concept is yield to worst. This measures the minimum yield the investor would receive if the worst case scenario were to occur, short of a default. For example, prepayment may be made on a callable bond which may result in a lower yield being realised. This concept of callability will be revisited further in the article.
The Concept of Duration
Most of us are familiar with the term or tenure of the bond. The term means that if a bond is issued today and has a tenure of 5 years, the bond will mature in half a decade with the investor receiving the principal and interest.
A higher level concept known as duration may be less familiar. The duration is the measurement of how long, in years, it takes for the price of the bond to repaid by its internal cash flows.
The reason why duration is often not the same as the tenure of the bond is because interest payments are spread out , and the principal is only paid out at the end of the term. If interest and principal payments were to be concentrated at the maturity date, then the duration would equal to the tenure of the bond, as in the case of a zero-coupon bond.
The concept of duration is useful for determining the volatility of the bond. A bond with a longer duration is more volatile than one with a shorter duration. Similarly, a bond with a longer duration will be more sensitive to interest rate changes than one with a shorter duration
Types of Bonds
Bonds may be subdivided into three categories: government, corporates and municipal.
Government bonds is debt issued by the governments of various nations like France, Germany or the United States. These bonds are usually guaranteed by the faith and credit of the issuing government and are issued on an unsecured basis. Government bonds are usually issued in the national currency of the country.
The second category is corporate bonds. Corporate bonds is debt issued by a corporate entity, usually large private or public companies. The bonds may be issued secured or unsecured. Companies often issue bonds to finance business expansion.
The third category is municipal bonds also known informally as munis. These securities are issued by local governments and districts. Some examples of issuing entities include the state of California in the US and State of New York.
Bond Ratings and Rating Agencies
We now know that the bond market is made up of bond buyers and sellers. On the buyer’s side, we have individuals and institutions looking to invest their money and generate returns. On the seller’s side, we have institutions and governments looking to raise money to fund business expansion and social programs.
In any given year, there are tens of thousands of institutions seeking to raise money. Some of them come to the marketplace with rock solid credentials while others come from more dubious backgrounds.
Most investors do not have the time or desire to conduct complex research on the financial status of the bond issuer. At the same time, they need to make prudent decisions on choosing the right issuer.
So how do investors separate the wheat from the chaff? This is where bond ratings come in.
Bond issuers engage an independent ratings agency (such as Moody’s, S&P or Fitch) to conduct research on the company and rate the company. This bond rating expresses the opinion of the rating agency on the credit worthiness of the issuer.
Credit worthiness is rated on an alphabetical scale, which differs according to the credit rating agency. For example,S&P adopts a convention where investment grade bonds typically carry an ‘A’ rating or better while a Junk or speculative bond carries a rating below BBB. Readers should not that different agencies utilise different rating conventions.
Special Bond Characteristics
Most bonds are issued by the company and repaid on maturity. In some instances however, companies may choose to issue bonds that allow them to redeem the security at some point before the maturity date. For example, the bond issued in 2013 may mature in 2018. If the bond had a call provision, it may allow the issuer to redeem the bond, at a predetermined price, every year from 2015 onwards. Note that in a callable bond, the issuer has the right, but not the obligation to redeem the security before the maturity date. In essence, when one purchases a callable bond, he is buying a bond with an attached option.
Institutions issue callable bonds to give them more flexibility in the management of their financing needs.
Zero Coupons Bonds
A zero coupon bond is a special fixed income security which does not pay a coupon during its term. A zero coupon bond is purchased at a lower price than the face value. When the bond matures, the face value (or principal value) is repaid.
The total return of a zero coupon bond is thus the difference between the face value of the bond and its purchase price.
Closely related to the preceding concept, a stripped bond is produced when a regular bond has its two components (Principal and coupons) split. This creates two new securities which are sold separately to different investors. The principal component becomes a zero coupon bond.
Contingent Convertible Notes
Contingent convertible notes, also known as Cocos, are almost identical to regular bonds apart from a few key differences. Cocos are converted to equity when a certain event occurs, for example when a bank’s tier 1 ratio falls below a certain level of if the company’s stock price exceeds a certain threshold.
The primary advantage of issuing Cocos as opposed to equity is in Earnings Management. When a company calculates its Earnings per share metric, it is not required to take the amount of Cocos issued into account.
A secondary advantage is that Cocos allow institutions to buttress their finances in times of stress, by converting the debt securities into equity.
Also known as Treasury Inflation Protection Securities, TIPS allow investors to protect themselves against the negative effects of inflation. The value of a TIPS security rises in line with inflation. TIPS are available largely in the US and may be purchased directly from the government.
Collaterised Debt Obligations
A collaterised debt obligation, also known as CDO, is not a bond but may be considered to be a fixed income product. It is a structured asset based security and is essentially a pool of bonds or loans. After pooling these loans together, the structure is sliced into tranches of different ranking. The individual tranches are then sold to different investors.
CDO tranches are usually ranked in status and priority. Some tranches may be deemed to be more senior to the other tranches. In the event where certain loans default, and the cash collected by the CDO structure is unable to repay all the investors, the more junior tranches will lose value first. That is the primary reason why Junior tranches often come with higher yields.
In conclusion, fixed income products can constitute extremely interesting financial investments. As these securities provide fixed regular payouts, they complement the retirement portfolio of the average investor. Before deciding on how much funds to allocate to this asset class, one should seek advice from their financial consultant, who will be able to provide personalised advice on asset allocation.