What Are Bonds and How Do They Work?

A bond is a debt investment where investors lend money to an entity for a defined period of time at a fixed interest rate. As most investors are looking to reduce risk during the recent turbulent markets many want to limit equities exposure while still pursuing capital growth. This is where bonds come into play and we’ll cover this topic in great detail in this article. By understanding what bonds are and how they work, you’ll soon see nearly every investor can benefit by investing in bonds

Types of Bonds

Bonds may be issued by a corporation or a government entity and are rated by independent companies based on their credit worthiness. After all, a bond is basically a loan so the issuer’s credit is an important factor in the interest rate they must pay. When an entity issues a bond, they are making a promise to the bondholder to pay a certain amount of interest at specified times throughout the life of the bond. Then, at the expiration of the bond, they are to repay the principal of the bond. If a bond is issued by a company it is called a corporate bond while those issued by the UK government are called gilts. Our focus will be on corporate bonds in this article, although many aspects of bonds will be shared by both corporate and government bonds. The biggest difference is that gilts are considered risk-free, since they are issued by the UK government, and therefore would generally pay less interest than corporate issues.

Understand the Value of Bonds

Bonds may be issued in denominations as small as £100, but often require purchases of £1000, or even £10,000 or more. The original amount that the bond was issued for is called the face value, nominal value or par value and the yield when the bond is issued is called the coupon yield or coupon rate (or just coupon). That value never changes for the life of the bond, although the price it is traded for will fluctuate greatly from the time the bond is issued until it is called for payment. This is how the interest rates are affected on the bond on the open market and even at issue. Bond prices and interest rates have an inverse relationship, so as interest rates rise, the price of bonds lowers and vice versa. Bonds are usually sold at a % of par value. If a bond is currently selling at 97, that means it is selling at 97% of the nominal value of the bond. They can also sell at more than face value, for instance a bond may sell at 103 or 103% of face value, when interest rates have fallen since the bond was issued. If it sounds confusing, well, it is at first. Let’s walk through some examples to clarify things.

For instance, let’s say ABC Corporation issues a 20 year bond paying 4% annual interest with a £1000 face value. They will pay bi-annual interest, so the owner of the bond will receive £20 twice yearly for 20 years, (£1000 x .04)/2 = £20. At the end of the 20 years or whenever the bond is called for payment (more on that later), whichever comes sooner, the owner of the bond will receive their £1000 back. Now let us imagine that interest rates are rising and in order to be competitive, this bond must now pay 5% annual interest. The company cannot change the coupon rate or the amount they are paying (£40 per annum), so instead, the price that the bond is trading for lowers. Remember, as interest rates rise, bond prices lower. If the bond price lowers to £800, then £40 is now 5% interest. We can figure this out by dividing the interest payment by the interest rate (£40 / .05 = £800).

We can also figure out the current interest rate if we only have the sales price and coupon rate. For example, if a bond is selling at £900 and the coupon rate is 4.2% (£42 per annum), then we can take £42/£900 to get approximately a 4.7% current yield.

Also keep in mind that if the bond is not called until the 20 years comes, then the current owner of the bond will receive face value or £1000 for each bond held. If the bond sold for £800, then this is a £200 premium on the price paid for the bond from which the final bondholder will benefit. This must also be taken into consideration and will affect the bond’s yield. So using our example above, the current yield on the bond is 5%, but the yield when the bond matures, called the yield to maturity, may be slightly more than 5% because of the extra principal payment that the bondholder will receive. The formula for this is very complex but this yield is most often the one printed when one is shopping bond prices.

Yield to Call

Another yield that will sometimes (not often) be seen is the yield to call. Again, the formula is very complex, but you should know that the yield to call takes into account the call features of that particular bond. The call features include the call date and the call price. When a bond is called, it is basically redeemed by the issuer at an earlier date than the maturity date.

Most corporate bonds have a call feature built-in, often with a set period of time to pass before they have the option to call the bond. This is referred to as call protection and the longer the period of time before the issuer may call the bond, the better for the bondholder. When a bond is called, it will be paid at par value or in some cases at a premium to par value. The terms are set forth when the bond is issued. The premiums are also a benefit to bondholders, since they will receive more than they originally paid for the bond.

The reason a company may want to call a bond could be because during the time that the bond has been issued, interest rates may have fallen. If interest rates have fallen over time, the corporation may look to call in their older, higher interest rate debt, in order to issue lower interest debt, or they will retire the debt altogether. In fact, often times the new issue will coincide with the call of the old bonds and funds from the new bond issue will be used to pay off calls on the old bond. This is why a longer call protection period is good for the bondholder – bondholders are then able to collect interest for a longer period of time. Let us look at an example.

XYZ Corporation issues a 30 year bond with 7% bi-annual interest. It has call protection of 10 years, so this bond cannot be called for redemption for at least 10 years. Imagine that in 3 years from the bond’s issue, interest rates drop to an average of 5%. Holders of the original bond are getting an incredible rate of interest, which they can continue to collect, or if they wish, they may sell the bond on the open market for a nice premium. Remember from above, as interest rates drop, bond prices rise, but the bond issuer will always have to pay the coupon rate, no matter what the current interest rates are. The higher price of the bond will result in a lower effective interest rate for the new bondholder, closer to the 5% average rate rather than the 7% coupon rate. However, as time gets closer to the call period, you would imagine that XYZ Corporation would want to call this bond and reissue their debt at the lower interest rate, saving the company a very large amount of money each year. For this reason, the premium that a seller could get on the open market reduces as the call period gets closer. People are not willing to pay a premium for a bond with a good interest rate considering that the bond will likely be called in a short period of time. Therefore, if there is a long time to the call period or longer call protection, the bondholder has more options available to him.

Bonds are Generally Safe Investments

Bonds are not the most exciting investment by any means. They are not flashy and you do not hear of people becoming millionaires through bonds. However, they are a very important part of a diversified portfolio. Although they may not make millionaires at the rate of stocks or other investments, you can be assured that millionaires and savvy investors around the world are using bonds to manage cash flow, create reliable income, and help protect their portfolio over the long term.