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The final part of the series on financial products and practices presents Bonds 1.01
Ever heard anyone talk about investing in stocks and bonds? It’s a relatively common expression, but one a lot of people only half-understand. Everybody knows what stocks are and why you might invest in them. But what are bonds. Be honest, do you really know?
Bonds are debt-instruments. If Nocash Corp wants to borrow money, it has two main options. It could go ask a bank for a loan, and in return get a lecture about things like the challenging liquidity environment. Or it could issue a bond.
Issuing a bond is a bit like issuing shares except that shares are equity and bonds are debt. Instead of asking one or two banks to lend it some money Nocash Corp asks a load of investors if they would like to buy bonds. And buying a bond is making a loan. If you hold a $1,000 bond issued by Nocash Corp, then Nocash Corp owes you $1,000. Simple.
Bonds have a few important features that theoretically enable investors to decide whether to buy them or not and at what price. These features are the price, the face value, the coupon (which is another word for interest), the rating, maturity and the yield.
The simplest features are the price and the face value. You might think that the price for a $1,000 bond would be $1,000, but it rarely is. The price that you pay for a bond is quite often less than its face value. This is particularly apparent in the case of bonds that don’t pay interest.
For example, if you are the government of Debtistan and you want to borrow money to build some roads and hospitals and things you might consider issuing a government bond. Now you probably don’t want to pay interest every year to the people who buy the bonds, so you issue what is called a zero-coupon bond, basically a bond that doesn’t pay interest.
Now if I’m an investor, I’m not going to buy a $1,000 bond from you or anyone else if all I can expect to get back is my $1,000 in three year’s time. I want to get a return. If I can’t get it in interest, I will get it in capital gains. So what happens is that when you sell me a $1,000 bond, I might only pay you $900 for it. Assuming you don’t go bankrupt before the bond’s maturity, which is the time when you have to pay me back, I will eventually get $1,000 from you in return. The $100 difference is my return on investment.
Once I’ve bought the bond, I can theoretically sell it to someone else. But the price I can sell it for is going to depend on the market’s perception of the credit quality of Debtistan. If the Debtistan economy starts to improve and the treasury’s coffers start to fill up with surplus tax revenue, then the credit quality of Debtistan will be perceived to have improved and I might be able to sell my $1,000 bond for $950, and make a $50 profit.
On the other hand, if six months after I buy the bond there is a coup detat and the new regime announces that it will not consider itself bound to any of the tyrannical capitalist lending arrangement made by the previous government, then the most I will be able to get for the Debtistan $1,000 bond will probably be about $1.50.
Of course, not all bonds are zero-coupon and the interest or coupon that a bond pays is also pretty important. If you buy shares in Nocash Corp you are generally entitled to receive dividends, assuming they declare some. Dividends are based on how well the company performs and how much cash it has left over at the end of the year. As such, dividends are uncertain and how much the company pays to shareholders is really up to its board’s discretion.
The interest payments on bonds on the other hand are fixed at the time they are issued. Whether the company performs well or poorly it still has to pay bondholders whatever rate of interest the bond requires.
Interest rates and issue price are supposedly based on the credit-quality of the company or government or municipality issuing the bond. And the way this is normally expressed is through a credit-rating. A bond that is rated AA+ is going to pay a lot less interest than a bond that is rated BB-. When an company is planning to issue a bond they generally will go to one or all of the big rating agencies and ask them to provide a rating. And they pay the rating agencies a fee for providing doing this.
Investors then largely rely on the rating agencies’ opinions in deciding how much interest or discount is appropriate for that bond. I don’t want to get into whether this is sensible or whether rating agencies ever make mistakes, but I will say this, the AAA-rated sub-prime mortgage-backed bonds were not a good example of this system working.
The other important factor is the maturity. Maturity is the time at which the issuer has to pay back the face value of the bond to the bond holders. If Nocash Corp issues a three-year bond with face value of $1,000, then no matter how much they sold it for, or how much it is trading for, at the end of the three years they have to come up with $1,000 for each bondholder. A lot of the time they will do this by issuing a new bond, but that’s another story.
The return on investment that a bondholder will make then is the interest if any that the bond pays, plus any capital gains in the bond’s price. Let’s look at an example. Suppose Nocash Corp issues three-year bonds with face value $1,000 and a coupon or annual interest rate of 5%. If one year after they are issued you buy one of these bonds for $980 and hold it for two years you will make a $20 capital gain and receive a total of $100 in interest, a total return of $120.
In this scenario, before buying this bond your broker will tell you the “yield”. This can mean a few different things but will generally mean either the “current yield” or the “yield to maturity”. The current yield is the annual interest rate that the bond pays, based on your purchase price.
In this scenario the current yield is not 5%. It would be 5% if you purchase the bond for $1,000, but bonds pay interest on their face value, not their purchase price. So here, the bond pays $50 a year in interest, but your purchase price is $980, so the current yield is 5.1%. This is interesting if all you want to know is how much interest you will earn. But if you want to know your total return, including capital gains, you would look at the yield to maturity.
Yield to maturity is the total return you will make on your purchase of the bond up until it matures, and so includes capital gains. This is one of those complicated calculations that includes a net present value element and is too complicated to be carried out by anyone other than a maths genius, an analyst with a financial calculator in his hand or anybody else who can type “yield to maturity” into Google and find an on-line calculator. Anyway, for our bond, it is 6.1%.
The slightly counter-intuitive thing about these calculations is that as the price of the bond goes down, the yield goes up and vice versa. If the price of this bond was $900, rather than $980, the current yield would be 5.5% and the yield-to-maturity would be 11%. The reason for this is simple, the lower the price the higher the interest payments are as a percentage of the price, and the larger the theoretical capital gain. The tricky thing about it this that it can be difficult when people say that bonds “dropped” is whether they mean bond prices dropped or bond yields dropped, which mean opposite things.
And just like every financial instrument, there are an uncountable number of permutations of the bond. The following table sets out a few examples of the variations that are out there.
Convertible – A convertible bond is generally one which starts out its life as a bond but at some point can be converted into equity in the bond issuer, at a pre-determined price at the bondholder’s discretion. In other words it is a bond with an equity call option attached.
Callable – A bond that can be redeemed by the issuer. If Nocash Corp issues a callable bond with a 5% coupon and interest rates drop to 4%, then Nocash Corp would be able to buy back the callable bonds, probably to re-issue them at a lower interest rate.
Inflation-linked – Usually issued by governments, inflation linked bonds generally pay a lower interest rate than normal bonds, but the investors’ return is linked to inflation. The higher the inflation rate the higher the yield.
Mortgage-backed – Probably not necessary to explain this. A bond that sounded like a really good idea at the time.
Step-Up – A bond that pays two or more different rates of interest. A step-up bond might pay 3% interest for the first 3 years, and then 5% interest for the next 3 years.
Junk – A junk bond is a relatively more risky bond and is usually defined as a bond that has a credit-rating of less than BB. These are often called high yield bonds by reference to the fact that because they are of low credit quality, they tend to pay more interest.
Floating rate – While most bonds have their interest rates or coupons fixed at the time of issue, some can have an interest rate that moves over time. A floating rate bond’s interest rate will be defined by reference by an index, such as LIBOR + 0.20%.
Sub-ordinated – Not all bonds are created equal. It is possible for Nocash Corp to issue two sets of bonds that have different rights to repayment. If Nocash Corp issues a standard bond and a subordinated bond, then the standard bond (called senior) gets paid first and the subordinated bond gets paid only if there is enough money left over. The subordinated bond is riskier and so has a higher yield.
Bearer – If you’re a villain in a movie, you will demand the ransom in bearer bonds. These things really exist and were once very popular. Just like the movie plots suggest, whoever happens to have possession of a bearer bond at the time of its maturity is entitled to repayment of the principle. Bearer bonds have coupons attached to them that can be torn off and presented to the company to collect interest. In Mission Impossible Tom Cruise demanded payment for the “NOC List” in the form of bearer bonds, “coupons attached!”. That meant that he planned to tear off the coupons and present then to the issuer and claim his interest once every six months. Because of their popularity with money launders and tax evaders, companies in the US can no longer issue bearer bonds, but they are still quite popular in other parts of the world.
So how do you buy bonds? They are not like shares in that you can’t go buy bonds on the internet. Instead you need to go through a broker. Depending on how popular a particular bond is, your average bond broker will be able to buy bonds for you at market price in a similar way that a broker might buy shares for you at market price. And just like when you buy shares your broker adds his fee into the price you end up paying.
And finally, why would you buy bonds? In the past investment advisors would tell you that bonds are more stable than equities. I’m not sure that they say this anymore, as bond prices have plummeted thanks to the recent financial hiccough the world has experienced. Now, investment advisors say that the only place to get decent interest, since the banks have pretty much decided to stop paying interest on deposits, is in bonds.
And this is true, kind of. The missing piece of information in this statement is that bonds are not risk free. The obvious twist is that the higher the interest rate is, the higher the risk. And just like shares, bonds can go up in value and down in value, and just like shares, when issuers go bankrupt, bonds can end up being worth very little.
Bonds 1.01
Sunday, June 21, 2009
