What are bonds, types, where do they come from and how do they work. What are bonds, types and properties of bonds Bonds in simple language
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Those who are far from financial markets are most likely unfamiliar with the concept of “bonds”. And this is one of the most convenient and profitable tools for obtaining a guaranteed income for every citizen. Let's look at the basic concepts, types, their risks and tell you how to invest in this type of securities and how you can make money on it.
1. What are bonds in simple words
Let's start by exploring the roots of this question: "who needs bonds and why and how do they come about?"
There are many companies in the world and almost every second one needs money (a lot of money) to develop their business. Taking out a loan from a bank is not profitable due to high interest rates. Therefore, they came up with an alternative type of loan through debt securities - bonds.
Bond(from the English "bonds") is a debt security for which you can receive a pre-agreed guaranteed income over time. Their owners are called “bondholders” in slang.
With bonds, a company borrows money directly from investors at an agreed interest rate and term. Upon expiration of the term, she undertakes to buy them back at face value and pay a reward (coupon) for them. In case of refusal to buy them back from the holders, the company will automatically be assigned a default.
The interest rate at which bonds are issued is usually slightly higher than the average interest rate for bank deposits and significantly less than a bank loan. This scheme allows everyone to benefit: for an investor, this is a chance to profitably invest a large amount of money at a good interest rate and not worry that the bank’s license will be taken away. And it is profitable for the company to raise funds at a significantly lower interest rate than a bank loan.
Also a big plus for investors is that it can be sold at any time without losing profit on it. In a bank, most deposits must be kept until the end of the term. In case of early closure, the investor will not receive the accumulated interest.
With this type of security, the investor has more options in terms of money management. If he sees some profitable opportunity to make money somewhere else (for example, by speculating in currencies or stocks), then he will quickly be able to sell the bonds (without losing interest) and then manage the money at his own discretion. Moreover, all this is done on one trading (exchange) account on the MICEX.
Note 1
Securities with a maturity of up to 10 years are often called " bill of exchange".
Note 2
Bonds are not issued in physical form. When purchasing them through the exchange, the investor is simply entered into the electronic register of bondholders.
Note 3
"Obligies" is often used in slang.
2. What are foreign bonds (Eurobonds)
Securities are issued throughout the world. There are so-called “foreign bonds”, which can be divided into 2 types:
- Foreign bonds (international bond). Issued by another state.
- Eurobonds. Issued by a Russian issuer in foreign currency.
Foreign bond is a security that is issued in another country in their local currency.
Russian investors do not have access to most of these securities. However, since 2014, it has become possible to trade on the American market (buy stocks and bonds) through our brokers. Detailed information about the possibilities of trading on the foreign market can be read in the article: how to buy foreign shares.
Eurobonds(eurobonds) are securities issued by Russian issuers in foreign currency. There are very few companies that do this. For example, Gazprom issued a Eurobond with a maturity of 15 years at 8.6% in US dollars. Such paper quickly rose in price and now costs 30-40% more than its face value. But if you buy it now and hold it for the entire term, the yield will still be impressive: 5.6% per annum.
You can read more about this type of securities in the article: what is a Eurobond
What is the reason for the weak popularity of bonds
It is logical that the average investor has the following question: “if bonds are so profitable, then why do so few people use this instrument?”
Having heard enough statements that “the stock market is a big risk,” “Forex is a scam,” most people do not trust anyone with their savings except banks (although hundreds of banks have closed over the past few years). Plus, many, due to their financial illiteracy, do not even know what benefits bonds provide compared to the same deposits. Some people are simply too lazy to go to a broker to open an account, although with the development of the Internet, the entire opening procedure is done online without any travel.
3. Bond terminology (dictionary)
Bonds have many different terms. All of them are intuitive after the first acquaintance. Let's look at a small dictionary of basic concepts:
1 nominal cost(face value) is the initial cost when placing. It is indicated on the bond itself. The issuer guarantees to buy back the entire issue at this price on the redemption day.
Most Russian bonds have a nominal value of 1,000 rubles. In the stock market, this is equivalent to 100%.
2 Market price(net value) is the price of a bond on the stock exchange, expressed as a percentage of the par value.
For example, 103% means that the market price exceeds the nominal price by 3% (1030 rubles). And 95% means that there is a discount of 5% (950 rubles).
3 Tax accrual on bonds(accumulated coupon income) is the accumulated amount of income since the last payment. Calculated every day.
For example, the rate is 12% and the company makes payments every six months (that is, 6%). 65 days have passed since the last payment. This means that at the moment the income tax is 65/183 × 6 × 100% = 2.13%. In other words, 0.0328% of the coupon will accumulate in one day.
For example, now the bond costs exactly 100% face value (1000 rubles). This means that the one who buys it now will automatically pay the NKD to the seller in the amount of 2.13% (this amount will be withdrawn from the brokerage account automatically). But no need to worry. Coupon income is accrued daily and if you sell it to another person, he will also pay it to you. If you simply hold the bond for the next 118 days until the issuer pays the ICD, you will receive a payment of 6% automatically. Taking into account the 2.13% that was paid, the net income for these days will be 3.87%.
Most often, on the MICEX the coupon is paid twice a year.
5 Offer- this is the possibility of early repayment. The repurchase price is offered by the issuer. To agree or not is the personal right of each investor based on the profitability of the offer.
6 Duration is an indicator for comparing the attractiveness of different bonds. It shows how many years later the invested money will be returned (not taking into account the nominal value). Naturally, the lower this value, the better.
7 Issuer is the organization that issues the bond. Below we will look at their classification.
4. What determines bond yields?
The more reliable the issuer, the lower the interest on income will be. For example, federal loan bonds (OFZ) are considered the most reliable in Russia. Their rates are approximately equal to the key rate of the Central Bank.
Private companies usually have higher rates. The more problems a company has, the higher the percentage of income will be, but the risk of bankruptcy is also higher. Plus, most often on such securities it is necessary to pay income tax on the coupon. But it is better to clarify this point, since innovations are constantly being introduced: since 2016, coupons for all commercial issuers are not taxed, but only for new issues.
You can also pay attention to credit ratings from international agencies. They will tell you the reliability of the issuer.
5. Types of bonds
Bonds are divided into many subcategories. Let's look at each one.
5.1. By payment method
- Discount(Zero Coupon Bond) - they are placed cheaper than their face value, and the company buys them back at the end of the term at face value (the difference between the starting price and face value is a profit);
- Fixed rate interest(Fixed Rate Bond) - involve periodic payment of income as a percentage; Most common;
- Interest with a floating rate(Floating Rate Note) - the same as the previous one, but the interest rate on payments may change (the revision dates are known in advance);
5.2. By issuer
- Commercial. Released by Russian companies. The average rate is from 6% to 15%. For example, this could be VTB, Gazprom, Sberbank, Russian Railways;
- Municipal. Issued by cities and regions. For example, Moscow and the Moscow region. The average rate is from 8% to 13%. Not subject to tax;
- State. The most popular bonds are issued by the state. Their name is Federal Loan Bonds (OFZ). Available from one year to 25 years. Average rate from 7% to 10% per annum; Not subject to tax;
- Eurobonds; Denominated in dollars. There is a small list of companies on the market that issue such bonds.
- Subordinated;
- Exchange bonds;
5.3. By maturity
This division is conditional
- Short term(up to one year);
- Medium term(from one year to five years);
- Long-term(over five years);
6. How to invest in bonds
Buying bonds yourself requires certain knowledge and skills. Many investors invest in portfolio bonds in investment funds (UIFs).
Every investment fund has such offers. Their meaning is to diversify risks, i.e. investing money in different companies and industries. Usually they promise income slightly higher than OFZ, while the chances of default are at minimum values.
1. General characteristics and classification of bonds.
- Maturity.
- Recall Disclaimer.
- Redemption fund.
- Classification of bonds.
- Convertible bonds.
Bond- this is emission security, containing a commitment issuer pay its owner (creditor) nominal price at the end of the specified period and periodically pay a certain amount percent.
General characteristics and classification of bonds
Bond (Bond) is
Bonds serve as an additional source of funds for issuer. Often their release is targeted in nature - to finance specific programs or objects, the profit from which subsequently serves as a source for payment benefits on bonds.
The economic essence of bonds is very similar to lending, but does not require the registration of debt security and simplifies the procedure for transferring the right of claim to a new creditor.
Usually profit on bonds is higher than the profit when placing similar funds in the form of a bank deposit. A comparison of current bond yields and loan interest serves as the basis for the formation of bond prices on the secondary securities market.
Bonds are issued by the state, local authorities or companies in the form valuable papers with a fixed or variable interest rate. Most bonds are unsecured and do not provide the right to participate in management.
Bonds are issued in the following types:
domestic and local credit bonds;
corporate bonds (corporate bonds).
A bond, like any other bond, has a price and can be bought and sold. bonds are formed on the basis of the balance of supply and demand.
Selling bonds can mean one of two things:
placement of bonds - that is sale bonds by the issuer to its first owner;
Sale bonds by its owner to a third party, who becomes the new owner of the bond, and to whom he is obligated to pay its face value and interest.
Bonds can be sold as follows:
Selling bonds at a discount, that is, when purchasing a bond, the future owner will pay for it less than the price indicated on the form;
Sale of bonds at par value;
Selling bonds at a premium, that is, when purchasing a bond, the future owner will pay for the bond an amount exceeding its face value.
A bond may provide for other property rights of its holder, if this does not contradict the law. Russia. Unlike holders of common stock, bondholders do not have ownership rights or an interest in the capital of the company or institution that issued the bond. This is due to the fact that bonds are credit obligations; bondholders only give duty theirs to the issuer; in this nature of the relationship, they do not receive an interest in the property or any other rights and privileges that may accompany participation in the property.
Bond (Bond) is
Bonds are a constant (in size) claim on the issuer's profit (determined by the amount of periodically paid interest), as well as a fixed claim on the issuer's assets (equal to the repayment amount). Bonds typically pay interest every six months. However, there are exceptions to this rule: in some cases, the interest payment interval is reduced to one month, and very rarely the payment is made once a year. The amount of interest paid depends on the coupon.
Coupon- this is a property of a bond that determines the amount of annual profit in the form of interest, but there are also zero-coupon bonds
The amount of the repayment amount (principal), often called the face value money issue or just face value issue of securities, determines the amount of capital that must be returned to the investor upon the occurrence of the established deadline repayment.
To facilitate the placement of bonds, the issuer breaks the entire issue into standard amounts called denominations. Of course debentures are regularly quoted at the market rate, which differs from the value of their face value. This happens every time the bet coupon specific bond issue differs from the prevailing market interest rate. The bond rate will change in the opposite direction relative to market prices interest rates until they become comparable to the prevailing market rate.
An issue whose market rate is below par is called a discount bond and usually has a coupon rate that is lower than the coupon rate on new cash bond issues. In contrast, cash issues with a market value greater than par are usually called premium bonds and have coupon rates higher than new issues.
Maturity
All debt securities have a limited life that expires on a specified maturity date - Maturity is the expiration date deadline the action of a bond when the principal amount of the debt is due to be repaid. Although bonds have a series of special interest payment dates, the maturity amount (principal) is paid only once: on or before maturity. Since the maturity date never changes, it not only determines the lifespan of the new currency issue, but also indicates the remaining life of the older bonds outstanding. When talking about duration of this kind, they mean the period until the bonds are redeemed. A new issue of securities may be in the form of a 25 year bond, but after 5 years it (that issue) will only have 20 years remaining to maturity. Based on the criterion of maturity, two types of bonds can be distinguished: term cash issues and serial ones.
Term bonds are bonds with a fairly long validity period until maturity that is the same for all.
Term cash bond issues are the most common. In contrast, serial bonds are issued with a series of different maturities, and the number of series in one issue can be up to 15 or even 20. For example, a 20-year bond issue issued in 1989 has a single maturity in 2009 However, the 20-year serial bond issue could have 20 annual maturities, which would be consecutive from 1990 to 2009.
At each of these annual dates, a certain part of the issued bonds, in accordance with the terms of the securities issue, is subject to redemption and redemption
In addition, the presence of a maturity makes it possible to distinguish bills from bonds. For example, debt securities that originally had a maturity of 2 to 10 years are usually considered bills of exchange, while bonds always have a maturity of more than 10 years.
Revocation clauses
Practically bills are often issued with maturities on the order of 5 to 7 years, while bonds typically have maturities ranging from 20 to 30 years or even longer.
If bonds are callable, they can be redeemed before the expiration of the specified period. And this is quite legal, since all bonds are issued with a call clause, which provides or does not provide for the right of early redemption, which determines the conditions for repaying the bonds before the expiration of the term set for them. There are basically three types of call clauses, or the right to redeem bonds early.
The bond is freely callable, meaning that the issuer can call for redemption at any time.
It may be irrevocable, which means that the issuer is prohibited from repaying the bonds before the expiration of the specified period.
The issue of securities may be deferred callable, which means that the bonds cannot be redeemed before the expiration of a certain period from the moment of their monetary issue, i.e., in essence, the issue becomes non-callable during the deferment period, and after This goes into the category of freely revocable.
Call clauses applied to bonds are in the best interests of the issuer. Such clauses are used in most cases to replace bonds of one issue of securities with bonds of another, later issue, with a lower coupon rate; the issuer receives by reducing annual interest payments. Thus, when market interest rates experience a sharp downturn, bond issuers (especially corporations and municipalities) authorities) repays its high-yield securities (by announcing interest rates and calling them) and replacing them with lower-yielding bonds. The final result is that investor will receive a lower rate of return on his investment than he expected.
A weak attempt to compensate for the losses of an investor who suddenly discovers that his securities are being called is the call (this is the amount added to the face value of the bond and paid investor when the bond is repaid early). The sum of these two payments (face value and revocable awards) is the call rate of the monetary issue and is equal to the amount that the issuer must pay upon early redemption of issued bonds. As a rule, it is provided that such revocable bonus usually on average equal to the value of the annual interest, if counted from the earliest possible date of commencement of the call, and the value of this premium gradually decreases as the maturity date approaches.
Instead of a call clause, some bonds may have a specific refinancing clause, which is almost similar to a right of early redemption (call) clause, except that this condition prohibits the premature redemption of an issue of securities from the proceeds provided by the investments issued for investment (replacement). old loan) with bonds with a lower coupon rate. This distinction is very important because it means that a “non-refunded” issue or a “deferred refinanced” issue can be bought back and paid off prematurely for any reason other than additional capital investment Thus, a high-yield (non-refinanced) bond may be faced with redemption only if the issuer has free cash flows allowing it to repay the issued bonds before the expiration of the previously established term for them.
Redemption Fund
A redemption fund is a clause that specifies the redemption amount of the bonds to be redeemed annually by the issuer during the life of the bonds.
Of course, a clause of this kind applies only to term money issues of bonds that mature on the same day, since serial money issues usually have pre-established redemption rules. Not all urgent cash issues of bonds contain a requirement for a redemption fund, however, for those of them, the terms of issue of which do provide for these requirements, the redemption fund establishes a special schedule of annual payments that regulates the redemption of the entire issue; it indicates the amount of denominations subject to annual redemption . Redemption fund requirements usually come into effect 1-5 years after the issue of money into circulation and remain in force until all (or most) of the issue is redeemed. Some portion of the securities issue that is not redeemed by the stated maturity date (it can range from 10 to 25% of the issue) will be repaid in the form of a lump sum loan payment. Similar to the call clause in bonds with a redemption fund, call is also used, although in this case it is purely symbolic and reaches only 1% (or even less) of the face value to be redeemed
TOlassification of bonds
Investor Encyclopedia. 2013 .
Synonyms:See what “Bond” is in other dictionaries:
BOND- (bond) A promissory note issued by a borrower to a lender. Bonds are usually issued by governments, local governments, or companies in the form of fixed interest securities. However, there is... Financial Dictionary
Each of us has had situations when our financial situation worsened and we needed to borrow money. Not only individuals need additional funds, but also organizations and governments. A bond is one of the methods of increasing capital. It has a lot of advantages, so it’s worth familiarizing yourself with it in detail.
Definition of the concept
A bond is a financial instrument that secures the right of its owner to receive from the issuer a security of its nominal value or other property equivalent within a specified period.
Bonds also imply the right of their owner to receive a fixed interest rate, calculated based on the face value. It will be income. In simple terms, a bond is a type of security that confirms that the issuer has borrowed money from the holder.
Types of bonds
There are several types of bonds.
- By income payment method. Bonds are divided into interest-bearing and discount bonds. In the first case, the issuer pays interest, called coupons, throughout the life of the security. This option is the most common on domestic exchanges.
- Discount bonds are issued below the face value of the bond. In this case, they are paid at nominal value. The profit of the security holder is the discount, that is, the difference between the issue price and the par value.
- By type of bond issuer. Securities of this type are corporate, municipal and state. In the first case, bonds are issued by joint-stock companies, as well as LLCs. The second type of securities is offered at the regional, city or district level. The Ministry of Finance of the Russian Federation issues government bonds.
- Eurobonds. This type should be considered separately. Financial instruments are issued by issuers to generate income in foreign markets. They are denominated in the currency of another state. The Russian Ministry of Finance and domestic companies issue bonds of this type, which are mainly denominated in US dollars.
general characteristics
The economic essence of these securities is similar to lending, but does not require debt security. In addition, the process of transferring claims to a new owner has been significantly simplified. It is worth noting that bank bonds have a similar feature. These financial instruments are more valuable than shares, as they allow you to obtain a pre-emptive right to return money in the event of liquidation or bankruptcy of the issuer. The high reliability of bonds makes them much more relevant for investors, which leads to their wide range.
For the issuer, a bond is an additional source of income. Their release is mainly targeted. It consists of financing objects or programs whose profits will become a source for payments. Typically, the income from bonds exceeds the income from bank deposits by a similar amount. In the secondary securities market, prices for these financial instruments are formed, the basis for which is a comparison of their profitability and loan interest.
Properties of bonds
Looking at bonds in detail, it is worth knowing that they have the following properties:
- security holders have priority in receiving profits;
- the transaction has a certain validity period;
- bonds differ in the amount of payments and frequency;
- Bondholders are given first priority to their financial claims in the event of bankruptcy or liquidation of the company.
Loan bonds are the main instrument for borrowing financial resources, which can be issued by the following structures:
- government agencies;
- government;
- corporations and companies;
- municipal institutions.
Regardless of the entity that issues the bonds, they have similar properties.
Features of bonds
Bonds have several features that should be considered without fail. The parameters for their release are considered to be:
- nominal value of financial instruments;
- volume of loan issue;
- profit margin;
- debt repayment terms.
The type of securities under consideration has a certain maturity date, according to which they are divided into:
- short-term bonds (up to five years);
- medium-term (up to ten years);
- long-term bonds with a maturity exceeding 10 years.
Securities of this type perform the following functions in the financial market:
- source of financing the budget deficit, regardless of its level;
- source of costs for public authorities;
- source of financing for deposits of joint-stock institutions;
- forms of saving money for companies, financial institutions and the population;
- provide profit.
In world practice, there are a huge number of types of bonds. These tools allow you to set individual requirements for a transaction on the basis of which one market participant agrees to provide capital to another. The issue of bonds depends on their type and most often involves the establishment of conditions that are of interest to a certain group of creditors.
Methods of paying income on bonds
World practice provides for the use of one of several methods according to which bonds are repaid:
- stepped interest rate;
- fixed interest payment;
- floating rate of interest income;
- sale of securities at a discount;
- indexing of nominal value;
- carrying out winning loans.
It is worth noting that the simplest and most relevant form of profit payment is to set a fixed interest payment. A stepped interest rate involves defining several dates, after which the holder has the right to repay them in full or extend them to the next date. In this case, the rate will increase in each subsequent period of time.
If the interest rate is called floating, it means that it changes regularly. The procedure is carried out in accordance with the dynamics of the Central Bank discount rate or the degree of profitability of government securities. It is worth noting that some countries provide for the issue of bonds with a par value that is indexed taking into account the increase in the consumer price index, which is carried out as part of an anti-inflationary policy.
There are types of bonds that do not provide for the payment of interest. Their holders make a profit by purchasing at a discount and redeeming at par. There may also be special draws that allow bondholders to receive income in the form of winnings.
Determination of profitability
Bond yields differ in certain parameters. They depend on the conditions offered by the issuer. Securities that are redeemed at the end of the term provide for the measurement of the following types of profitability:
- coupon;
- current;
- complete.
Coupon and current yield
The coupon yield is the rate of interest specified in the document and paid by the issuer on the coupon. In this case, payments can be made once every three months, six months or once a year.
The current yield on a fixed rate bond is the ratio of the periodic payments to the purchase price. The indicator is capable of characterizing the annual interest paid on capital. However, the current yield does not take into account changes in the value of bonds over the period of their storage.
The indicator under consideration can change according to the prices established on the market. It is worth noting that it becomes fixed from the moment of purchase, since the coupon rate does not change. Additionally, bond prices and yields will be higher for discounted securities.
The current yield indicator does not take into account the exchange rate difference between the purchase and redemption prices. For this reason, it cannot be used to compare the performance of transactions with specific baseline conditions. To determine whether it is advisable to invest in bonds, it is worth using the yield to maturity indicator.
Yield to maturity and total return
The yield to maturity is the interest rate taking into account the discount factor. It establishes the difference between the current and market value of a stream of payments. The yield to maturity can be determined during storage; bonds are stored until full maturity.
With total return, the price of the bond and all possible sources of income are taken into account. This indicator is often called the premises rate. With its help, you can determine how effective the purchased security will be. Thus, you can avoid making mistakes when concluding a deal and make a profitable investment. Determining profitability will be useful both for individuals and legal entities, as well as for companies and municipalities that purchase the securities in question.
For a newbie to bonds, there is a sense of fear: this type of investing has a lot of technical terminology, strange concepts, and a lot more talk about math and economics than you might hear at a stock brokerage firm.
But don't despair. - are not as mysterious as they might seem at first glance. Let's first look at 10 key things you need to know about bonds.
- Bonds are not as complicated as they seem. Despite the fact that they are called by different names (fixed income securities, debentures, credit securities, etc.), bonds are just a type of promissory note, which stipulates in detail, in strictly legal form, the terms, date payments and interest rate.
- Bonds have a reputation as a reliable instrument. And for good reason. But this does not mean that working with them is not associated with risks. In practice, bond investors are concerned about things that stock investors are not at all concerned about - liquidity risks, etc.
- Bond prices move in the opposite direction of interest rates. When rates rise, bonds fall. And vice versa. If you buy a bond and hold it to maturity, fluctuations in interest rates and associated fluctuations in the price of the bond do not matter. But if you sell your bonds before maturity, the price you get will depend significantly on the interest rate situation.
- Bonds are more complex than stocks. While stocks have little variety and are offered only by publicly traded companies, bonds are sold by both companies and the federal government, government-sponsored agencies, municipalities, states and other public entities. The variety of bonds is almost endless - from short-term notes to bonds with a maturity of 30 years.
- Despite all the complexity, you need to understand that any bonds issued in the United States can be classified into one of three categories. The first is the highly secure debt obligations of the federal government and its agencies. The second is safe bonds issued by corporations, municipalities and states. These two types of bonds are called "investment grade" securities. The third are risky bonds sold by the same corporations, municipalities and states. These are so-called "speculative" or junk bonds.
- You can easily determine whether a bond is investment grade or junk grade (or somewhere in between). A number of Wall Street companies rank bonds based on their reliability. Such credit rating agencies, including Moody's, Standard & Poor's and Fitch Ratings, publish a simple rating scale for all debt obligations.
- The key to understanding the bond market is understanding the financial concept - the so-called. The "yield curve," which is a graphical representation of the relationship between the interest rate paid on a bond and its maturity. By learning to read the yield curve (and calculate the spread between the curves), you can intelligently compare bond issues.
- There is a whole class of bonds aimed at paying tax-free income. Municipalities and states issue . The interest paid on these bonds is not subject to federal taxes. But despite these considerations, municipal bonds are not for everyone.
- The bond market is the basis for other, more complex markets. Sophisticated investors can buy options on bonds just like they can on stocks. In addition, the bond market has spawned countless derivative instruments. The best known of these is credit default, which is used to protect investors from default risks.
- Much of the bond market lies in the dark, unfriendly backwaters of Wall Street, where small investors are especially vulnerable. The secondary, or over-the-counter, market is not recommended for the average investor. But the market is no longer as opaque as it was several decades ago. However, this is still not the place to be adventurous unless you have done some deep research and extensive negotiations. Thus, the vast majority of investors looking to venture into the new area of debt investing should buy bond mutual funds. Such funds do not have the liquidity risks inherent in individual bonds. Investors can use them to diversify their portfolio (when working with individual bonds, this option is available only to very wealthy investors). In the case of funds, purchase fees, markups, and other fees are fairly easy to determine. There are thousands of funds that do not charge premiums and keep fees to a minimum.
Although bonds are among the safest types of investment around the world, this does not mean that dealing with them does not involve risks. Let's look at some of the most significant dangers associated with fixed income securities.
- Inflation risk. While relatively safe, bonds do not provide very high returns. This makes them especially vulnerable when inflation rises.
Imagine, for example, that you bought a Treasury bond that pays 3.32%. This is the most reliable one you can find. If you hold these securities to maturity and the US government doesn't collapse, you'll be fine... as long as inflation doesn't rise. If the inflation rate rises to, say, 4%, your investment won't keep up. In fact, you will lose because the value of the cash you invested in the bonds will decrease. You will get your investment back when it matures, but it will be worth less.
However, there are exceptions to this rule. For example, the US Treasury also sells investment instruments such as Treasury inflation-protected bonds.
- Interest rate risks. The price of a bond has an inverse relationship with the interest rate. When one goes up, the other goes down.
If you need to sell bonds before they mature, the price you can get will depend on the interest rate situation at the time of sale. In other words, if interest rates rise after you buy a guaranteed income security, the price of that security will fall.
Interest rates on all bonds fluctuate. Calculating the vulnerability of any given bond to a change in rate involves an incredibly complex concept - duration. But the average investor only needs to know two things about interest rate risk.
First: If you hold the security to maturity, there is no interest rate risk. After redemption, you will receive back your entire investment.
Second: The most vulnerable to interest rate fluctuations are zero coupon investments, for which full payment is made when the bond matures.
To bearer. This is the borrower's obligation to repay the borrowed funds within a certain period of time and with certain interest.
In fact, when selling a bond, the state or organization takes a loan from the buyer, so the holder of this security has the right to receive annual income in the form of a set percentage. A special feature of a bond is that it must be redeemed within the period specified at the time of its issue.
In the financial markets system, bonds are also called bonds.
McDonald's bond
What is the essence of bonds?
The essence of bonds is similar to a loan - a certain amount of debt is also given, and the same planned income. The difference lies in the simplification of the procedure for a new lender and the unnecessary registration of collateral. Investments can be for a period of 1 to 30 years.
What types of bonds are there?
According to the type of issuer, there are three types of bonds: corporate, government, municipal:
- Corporate bonds are an obligation of an enterprise or firm to its creditors, the bondholders, to pay the debt and interest on it within a certain time frame.
- State and municipal bonds operate similarly to corporate bonds, only the debtor changes.
By maturity of bonds we can distinguish:
- short-term (repayment period ranges from 3 to 12 months);
- medium-term (from 1 year to 5 years);
- long-term (more than 5 years);
- unlimited
According to financial security, bonds are:
- Coupon – A bond that pays interest (that is, a coupon).
- Zero-coupon or discount bonds are bonds that do not provide for interest payments, but such bonds are put on the market at a reduced price.
- Classic or unsecured – bonds that are not backed by anything other than the credit rating of the issuer (the enterprise or state that issues the bonds).
- Secured - bonds secured by some property of the issuer.
By type of income, there are the following types of bonds:
- Discount - do not have a coupon, the profit is formed due to the discount (difference) between the nominal and current market values. The par price is fixed, so naturally the market price will increase (and earnings will therefore decrease) as the security's maturity date approaches. Discount debt securities have a lower trading volume and prevalence than the next type.
- Fixed Rate – A debt security that has a coupon payment at a fixed interest rate. Coupon payments occur mainly once every 4 months (sometimes once every 3 months, sometimes the frequency of payments is different).
- A floating rate debt security is a debt security that has a variable coupon, the amount of which is tied to certain macroeconomic indicators, such as interest rates on other securities or the refinancing rate. These securities are issued less frequently than fixed rate securities.
How are bond yields paid?
The yield payment on a bond depends on its type. Thus, on bonds with a fixed interest rate, income is paid in the form of a designated percentage at a certain period (for example, annually, quarterly). For example, you bought a bond with a face value of 1000 rubles. with an annual rate of 8% for a period of 5 years. Obviously, the annual income will be 80 rubles, and upon expiration of the bond, you will receive 400 rubles.
Floating rate bonds are tied to certain financial ratios. For example, to the refinancing rate. When this indicator changes, the yield on the bond also changes. For example, you bought a bond with a face value of 1000 rubles. for three years, the interest on which is equal to the refinancing rate +1%. The refinancing rate changed as follows: 1 year - 6%, 2 year - 7%, 3 year - 8%. Thus, the income on such a bond will be 70+80+90=240 rubles.
There are also mixed-type bonds, in which part of the income is paid at a fixed rate, and the other at a floating rate.
Another type of bond in terms of yield payment is discount bonds. There is no interest rate on them, and income is generated through a discount (price difference). For example, an issuer issues a bond with a face value of 2000 rubles, and sells them for 1000 rubles. Thus, your profitability when selling the bond will be 1000 rubles.
What is the bond market?
Government and corporate bonds are in free circulation on the so-called secondary securities market and the procedure for purchasing them is similar to purchasing shares.
There are so-called echelons in the bond market: the first (blue chips) and the third echelons. This is a conditional division of companies according to their size, stability, and reliability.
Accordingly, the yield on bonds from the first tier, the so-called “blue chips” (in Russia these are Gazprom, Rosneft, Sberbank, etc.), is much lower than the yield on bonds of the second or third tier, but also the guarantee of bond repayment (that is, the return of debt) significantly higher.
Examples of bonds
Vintage foreign bond from 1931
One of the oldest bonds found
Soviet bond
War bond
Bond: winning loan
As you can see, there is a huge variety of bonds. You can learn more about the different types of ancient bonds on websites dedicated to numismatics.