Bonds, a beginners guide

We hear about them every day but most would struggle to define them, I've put together a short guide to some Bond basics, enjoy!

What is a Bond?

Bonds are essentially IOU’s. When you invest in a bond you are lending money to the issuer. In return for the loan the issuer promises to pay your original capital back at the end of the term and interest payments in the intervening period. The rate of interest is decided before a bond is issued. It is also known as selling debt or ‘paper’.

Who issues Bonds?

Primarily bonds are issued by companies and governments but they can also be issued by local authorities or government bodies. Bonds are issued to help pay for particular projects or in the case of the Irish Government, just prior to the IMF intervention, for general day to day expenditure. Some governmental bonds issued directly to members of the public may carry beneficial tax implications vs. a bank account e.g. no DIRT/exit tax payable (see the An Post website for a list of their investments and the T+C’s that apply).

What is a Bond Fund?

Bond Funds are mutual funds that invest in bonds. These are usually accessed via an investment through a life assurance company.

Why invest in Bonds?

Generally bonds (and bond funds) seek to provide income and they are normally considered less risky than stock market based investments. Bonds help to provide diversification in a portfolio i.e. they can provide stability in turbulent markets. For example, the 3 year annualised performance of one particular European bond fund provided an annual return of c.6.2% compared to an average annual loss of  -9.79% on their European Equity fund during the same period.

How do you know that the issuer will pay you back?

The quality of a bond is based on the perceived ability of the issuer to pay its debt. Each bond is given a rating by a rating agency (Moodys, Fitch etc) from the highest quality (least risky) AAA to the lowest DDD. A bond is rated as ‘Investment grade’ if its rating is BBB- or higher. Bonds that are not rated as investment grade are known as high yield bonds or ‘Junk Bonds’. Generally the lower the rating, the higher the risk premium (interest rate) will be asked by investors.

How do Bond investors make money?

You can make money in two ways with bonds. First you can receive the income from the bonds interest payments. The longer the term of a bond the riskier it is considered and generally it will pay more interest. You can also sell on a bond on the ‘secondary market’ for more than you bought if for. The value of an existing bond is influenced in two ways, firstly the amount of income being realised from the bond (or ‘Yield’) and also the prevailing interest rate. Bonds are very sensitive to interest rate change; they have an inverse relationship, i.e. if the interest rate goes down, the value of existing bonds paying more interest goes up.

The Bond Market

A secondary market exists for the buying and selling of existing bonds. In the US alone $822 billion is the average daily trading volume. This is made up of commercial and governmental (or sovereign) bonds being traded by Institutional investors (e.g. life assurance companies), Governments (e.g. the National Pension Reserve Fund acting on our behalf) or Traders buying and selling on behalf of individuals. As ‘the market’ loses confidence in a company or a country they will vote with their feet selling undesirable bonds and driving up the cost of further borrowing for the issuer. It must also be said that volatility in the markets do not affect investors who buy a bond with the intention of seeing it through until maturity, their interest payments will continue annually as normal.