Bonds: types, profitability and risks

A bond is a type of security. A debt security in which you can receive a pre-agreed, guaranteed return after a certain period of time.

CONTENTS:

1) What a bond is
2) What are foreign bonds (euro bonds)
3) What does the yield of bonds depend on?
4) Types of bonds
5) How to invest in bonds
6) How to make money on bonds
7) Risks in investing in bonds
8) What is the difference between a deposit and a coupon
9) Long maturity – is it worth buying
10) Why the price changes
11) What does the yield depend on?

1) What a bond is

A bond is a debt security in which you can receive a pre-agreed, guaranteed return after a certain period of time. It has a limited term and at the time it ends, the issuer redeems the entire issue at face value.

Bonds are a type of security. Investing in bonds is very similar to bank deposits. Bonds are one of the most convenient and profitable instruments for obtaining a guaranteed income for any individual.

Regular bonds are traded on the stock exchange. They can be bought/sold during a trading session. The stock exchanges are accessed through brokers. Where, after registration, you need to open a brokerage account (which is an account where both money and securities can be kept at the same time) and make purchases.

There are many different companies in the world and everyone needs money (a lot of money) to develop their business. Many for the development of their business do not want to take a loan from a bank because of the high interest rates. And few banks are willing to give a huge loan amount for a long period of time. Therefore, an alternative type of borrowing through debt securities – “bonds” – has been invented.

A company, by issuing and selling bonds, borrows money directly from investors at an agreed-upon interest rate and term. At the end of the term, it agrees to repurchase them back at face value and pay a fee (coupon) on them. If the company refuses to repurchase them from the holders, it will automatically be assigned a default.

Default is a refusal or inability of a company/country to pay foreign debt. But it does not mean 100% bankruptcy.

The amount of interest on which bonds are issued is usually slightly higher than the average interest on bank deposits and much lower than a loan from a bank.

Bonds are issued by issuers. These can be large companies, the state (Ministry of Finance), or municipalities. Each bond has a specific maturity date (1 year, 10 years, etc.). The maturity date is called expiration. On that day, the issuer is obliged to redeem the entire issue at par.The coupon yield is approximately equal to the key rate of the Central Bank (refinancing rate). If the rate falls, the bonds go up in price, thereby reducing the yield for new buyers. Conversely, if the Central Bank rate rises, the price falls and the yield rises.

Through bonds:

  • the company – to be able to profitably raise funds at a much lower interest rate than a loan from a bank.
  • for an investor, it is an opportunity to invest a large amount of money at a good interest rate, without worrying that, for example, the license of the bank will be taken away and the investor will lose money. Also, a huge plus for investors is that the bonds can be sold at any time without losing the profit on it. Bonds are listed on the stock exchange and can be bought and sold. In a bank, most deposits must be held until the end of the term, and in the event of premature closure, the depositor will not receive the accrued interest.

In general, we can say that a bond is very similar to a bank deposit. But it has the following advantages:

  1. There are different maturities (1 year, 5 years and even 15 years). This means that you can reserve some income in advance for the entire term.
  2. You can sell at any time without losing the accumulated interest.
  3. Yield is higher.
  4. It is possible to invest any large sums.

With this type of securities, the investor has more opportunities in terms of money management. If he recognizes a profitable opportunity to make money somewhere else (for example, by speculating on foreign exchange or stocks), he can quickly sell the bonds (without losing any interest), and then manage the money as he sees fit. All this is done on a single trading (exchange) account at MICEX. Bonds are not issued in physical form. When buying them through the exchange, the investor is simply entered into the electronic register of securities holders (depositary).

Bonds with a maturity of up to 10 years are often called “promissory notes”.

2) What are foreign bonds (euro bonds)

There are so-called “foreign bonds” which can be divided into 2 types:

  1. Foreign bonds (international bond). Issued by another country.
  2. Euro bonds. Issued by a certain country in a foreign currency.

A foreign bond is a debt security that is issued in another country in their local currency and law. They are sometimes called “international” bonds. They are most often issued in countries with a developed financial market (U.S., Japan).

Foreign issues offer the following advantages to companies:

  • Low interest rates.
  • Wide range of institutional investors
  • Long terms of borrowing

In the U.S. they are called Yankee, in Japan Samurai, in Spain Matador, in the UK Bulldog.

Eurobonds are international debentures, issued by the borrowers (international organizations, governments, local authorities, large corporations, interested in reception of money for a long term from 1 year up to 40 years at the European financial market in any euro currency.

The prefix “euro” nowadays is a tribute to tradition, because the first Eurobonds appeared in Europe, and they are traded mainly there. Eurobond loans account for more than 50% of euro market turnover, and about 90% of the euro paper market turnover.

3) What does the yield of bonds depend on?

The more reliable the issuer, the lower will be the rate of return. The rate of return of private companies is higher. The smaller the company, the higher will be the rate of return, but the risk of bankruptcy is also higher. Plus, more often than not, you have to pay income tax on the coupon on such securities.

You can pay attention to the credit ratings of international agencies. They suggest the reliability of the issuer. Although you can understand your own risks by comparing the yield and price of different bonds. In almost all cases, the higher the yield, the lower the reliability and vice versa.

4) Types of bonds

Bonds can be divided by characteristics and types:

  • By method of payment.
  • By issuer.
  • By maturity.

A) According to the method of payment

  • Discounted (Zero Coupon Bond) – are placed cheaper than their face value, and the company redeems them at the end of the term at face value (the difference between the starting value and face value is the investor’s profit). This type is rare;
  • Fixed Rate Bond – assumes a periodic payment of income in interest. The rate is fixed and known in advance for the entire term of the security. Occur most frequently;
  • Floating Rate Note – Same as above, but interest rate of repayment changes according to some rules.
  • Inflation-linked yields – these have a fixed coupon, and their par value increases by the annual inflation rate. Such securities have not found widespread interest;

B) By issuer

  • Commercial or corporate.
  • Municipal. Issued by cities and regions.
  • State bonds. Issued by the state, the most popular bonds. Issued from one year to 25 years.
  • Eurobonds; Nominated in dollars. There is a small list of companies on the market that issue such bonds. Subordinated and Exchange-traded bonds.
  • Quasi-state. Issued by companies and organizations whose controlling interest is owned by the state.

C) By maturity

  • This division is conditional.
  • Short-term bonds (up to one year);
  • Medium-term (from one to five years);
  • Long-term (more than five years);
  • Perpetual (has no maturity, in world practice, it is quite a rare type of paper);

5) How to invest in bonds

Buying bonds yourself requires certain knowledge and skills. Many investors invest in portfolio bonds in investment funds (mutual funds) or ETF funds.

Every investment fund has such offerings. Their point is to diversify risk, investing money in different companies and industries. They usually promise a slightly higher income than ETFs. The risk of the collapse of these funds is at a minimum level as a result of broad diversification.

There is a fee for participating in such an investment portfolio. Some charge for the deposit and withdrawal of money, some charge for the terms of using such services.

I would like to remind you that anyone can open their own brokerage account for free and buy the bonds they want without any additional fees. You will choose what to buy and when to sell. The main thing is to choose a reliable broker.

Investing in mutual funds takes time (it will take a couple of days) and trips to the organization’s branch. There are bond ETFs on the MICEX market. When you buy them, you immediately buy a portfolio of bonds. There are government and corporate portfolios. The names of these ETFs are FXRB, FXRU, VTBB, SBGB. There are also U.S. Treasury securities (denominated in dollars). They’re also called treasuries. Such an ETF fund is called FXMM.

6) How to make money on bonds

Bond trading is similar to stock trading, but still has a number of differences.

When trading in stocks, the trader pursues the goal of earning from fluctuations and growth of the exchange rate. This is the main source of income. Profits from dividends can also contribute to a pleasant bonus to shareholders of this security.

On bonds, the investor receives a guaranteed income, albeit a small one. At the same time, if the key rate of the Central Bank decreases, the issues with a long maturity period will rise in price. Thus, if one foresees a rate decrease, one can earn a couple of percent in a short period of time (a month).

Bonds are a low volatility financial instrument. Short-term speculation is almost impossible. Usually they are bought for a while (at least a month).

7) Risks in investing in bonds

Let’s look at the list of risks for this class of securities. Despite their great reliability, there are problems here as well. For an investor in bonds, the following risks may arise:

  1. Interest rates.
  2. Credit/default risk.
  3. Early redemption.
  4. Risks due to low liquidity.
  5. Credit rating downgrades.
  6. Geopolitical risks.

1. Interest rate. If the key interest rate of the Central Bank increases, all previously issued bonds will depreciate in value. This is because it makes no sense for bondholders to hold bonds at a low interest rate when new issues come out at a higher interest rate. For example, it was 7% and now it is 9%. Everyone will rush to buy the new issues while selling the old ones.

So remember the simple rule: if the Central Bank rate goes down, long-term bonds go up in price. If the Central Bank forecasts a higher refinancing rate, long-term bonds will fall the most.

If we consider short-term options (1-2 year maturity), their value is virtually unaffected. Therefore, interest rate risk is long-term in nature.

2. Credit/default risk. There is always a chance that the issuer who issued the bond will not be able to pay its obligations or redeem it. In this case, it may default, which means investors will only get a portion of their money back.

This risk is greatest in small companies or troubled ones. Naturally, if we are talking about OFZs, these are super reliable bonds and the risks tend to zero.

3. Early redemption. If the bond is revocable (that is, the issuer can redeem it in advance), then there are risks that it will be redeemed, and you will be left with an amount of money that is unclear where to put it. Your investment plan may have been designed to generate income for years to come. Now you will have to revise it.

4. Risks due to low liquidity. Many bond issues have little liquidity. This is especially noticeable in second-tier companies. For example, you have a bond of such a company. It may be very difficult to sell, as the order book may be half-empty or offer unprofitable prices.

Again, this situation does not arise with OFZs, as they are much more liquid.

5. Credit rating downgrades. The issuer who issued the bond has a credit rating. In fact, this is an assessment by the respective organization. Investors and banks pay close attention to this data.

For example, if the credit rating goes down, it will cause a sell-off in the bond as the chances of bankruptcy increase due to more expensive credit for that company.

6. Geopolitical risks. There is no way to predict this risk, it can flare up with new strength or subside. The stock market will react violently to all news and announcements. Even such a conservative instrument as bonds can “jump” in value. That’s why we recommend that you keep some of your money in short-term securities to reduce your risks.

8) What is the difference between a deposit and a coupon

Bank deposits are opened for a certain period of time (just like bonds). However, holders of a bond can sell it without losing the coupon income accrued over the life of the security. Almost all bank deposits do not imply early closure without loss of interest.

Due to the coupon income, bonds have much more flexibility in money management. You can quickly move them into assets that start to grow (for example). In addition, coupon income gives a higher yield than bank deposits.

9) Long maturity – is it worth buying

All securities that are placed with a long expiration date carry a lot of risk. Because of this, you should sensibly consider options for investing in them.

For instance, you can buy a 3-year bond with a yield of 7.8% or a 10-year bond with a yield of 8.1%. In my opinion, it is obviously much safer and more sensible to invest in the former. What is the point of taking a risk for the sake of 0.3% per annum? Risk implies an increase in the Central Bank’s key rate or other geopolitical risks.

It makes sense to buy long-term bonds when their yields are substantially higher. So that risks can be justified by high returns.

10) Why the price changes

If this type of securities gives a stable income, why do prices of bonds change all the time? This question often arises among beginners. The answer is: investors rely on current interest rates (the Central Bank key rate) and use them to calculate returns. If it changes, it can be so that long-term issues become very profitable (when the rate is 6%, and the yield on securities is 8%) or on the contrary unprofitable.

This difference in yields can only be compensated for by the price. The greater the deviation between a bond’s coupon yield and the key rate, the more volatile the price changes.

If you don’t want to experience high volatility, buy short-term issues (maturing within 3 years). Their price is little affected by changes in the key rate.

11) What does the yield depend on?

A bond’s yield depends on the following things in the aggregate:

  • Coupon size.
  • Frequency of payment.
  • Maturity.
  • Amortization.
  • The offer.
  • The current price.

If the price is cheaper, then the yield is greater? But it is not. For example, the yield to maturity may be 10% and the price is 90.4, and another may have 12% with a more expensive price of 95.5.

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