The first thing that comes to mind when talking about investing is the stock market. It is true that the world of stocks is exciting. Market movements are dissected in the newspapers and on television.
Bonds, on the other hand, are not as sexy. The jargon surrounding this type of financial product can seem arcane to the uninitiated. Also, bonds are much more “peppy,” especially in bull markets, when they seem to offer a meaningless return compared to stocks.
However, it only takes a bear market to remind investors of all the virtues of bonds: safety and stability. In fact, for many investors, it’s natural for a portion of their portfolio to be invested in bonds.
Discover in our guide what a bond is, how it works, what differentiates it from a stock, its advantages. Also find our state of the art of the global bond market and our focus on how to invest in bonds today.
Bond: a negotiable debt security
Just like individuals, corporations and governments need to borrow money to finance their projects. A company needs money to expand into other markets, and governments need money in areas like infrastructure and social housing. So the solution is to raise money by issuing bonds in the financial markets. In this way, thousands of investors each lend a portion of the capital.
A bond is a debt security issued by a company or a government entitling the investor to the payment of an annual interest called a coupon and the repayment of the security at maturity. The amount of this coupon, as well as the maturity of the bond, are fixed at the outset and therefore known to the investor at the time of subscription.
Government bond, corporate bond and convertible bond: what are the different types of bonds?
There are 3 main types of bonds:
Government bond
In this case, they are securities issued by states to ensure the financing of their debt.
Corporate Bonds
In this case, they are securities issued by a private company to provide debt financing.
Convertible bond
A convertible bond is a particular type of corporate bond with a conversion right attached to it, which offers the holder of the security the opportunity to exchange the bond for shares in the issuing company at a pre-determined conversion ratio and during a predetermined period.
Bond: what yield and what investment duration?
In reality, the bond is nothing more than a loan that makes you the creditor of the company. The entity that sells the bond is called the issuer. You can think of the bond as the debt of a borrower (the issuer) to a lender (the investor).
Of course, no one would lend their hard-earned money for nothing. The issuer of a bond must pay a premium to the investor in exchange for the privilege of using his money. This premium is paid in the form of interest that is set at a predetermined rate. The interest rate is often referred to as a “coupon”. The date on which the issuer must repay the amount borrowed (called the face value) is called the maturity date. Bonds are fixed-income securities because you know exactly how much money you will get back if you hold the security to maturity.
For example, let’s say you buy a bond with a par value of €1,000, with an 8% coupon and a 10-year maturity. This means you will receive a total of €80 (€1,000 x 8%) in interest per year for the next 10 years. In fact, since most bonds pay interest semi-annually, you will receive two payments of €40 each year over 10 years. When the bond matures, your €1,000 (the “principal”) will be paid back in full.
Bond: what rate for what risk premium?
Depending on its issuer, a bond is more or less highly rated and more or less profitable. This is because rating agencies assign ratings to different issuers, whether they are countries or companies. The higher the rating, the lower the risk of default and the lower the return. Conversely, the lower the rating, the higher the risk of default and the higher the return. It is then up to the investor to diversify his investments with relatively safe but low-yielding bonds and riskier but higher-yielding bonds. Ratings range from A to D. A debt security issued by a company rated BB or lower is considered a speculative investment.
Companies or governments that are likely to fail will therefore only be able to borrow at a higher rate, which can sometimes worsen the financial situation of the company or government in question. So be careful with high-yielding bonds, referred to in Anglo-Saxon jargon as “junk bonds.”
Investors will often not wait for the rating agencies to raise or lower the rating of a company or state to review the borrowing terms and rates. Indeed, bad or good news about the financial health of a government or company will have an almost instantaneous effect on the bond market. The repercussions can impact both the primary (issuance) market as well as the secondary market in which investors trade previously issued bonds to their maturities.
Bond: how to calculate the actuarial rate of return
To calculate the actuarial rate of return on a bond, two factors must be taken into account:
- The purchase price of the bond
- The coupon rate
Examples of bond yields and bond prices
Many investors will look only at the coupon rate to estimate the yield on a bond. This may not be enough to get a correct estimate of the profitability of a bond investment.
Actuarial yield on a bond in the primary market
When an investor buys a bond when it is issued, in what is called the primary market, then the price of the bond will always be 100 EUR/USD/GBP. This does not mean that the minimum investment size will be EUR 100. On the contrary, the minimums required in the bond market are often high.
In this case, the calculation of the yield is simple, as you only need to take into account the amount of coupons until maturity. The amount repaid at maturity will be 100 euros.
Actuarial yield of a bond on the secondary market
As explained above, all information related to the financial health of a bond creditor company will have a direct impact on the price of the bonds and more specifically on the secondary market. The secondary market encompasses the stock market trading of previously issued bonds.
The secondary market is the market for bonds that have already been issued
Thus, a bond purchased for €100 may only trade for €90 if the issuer’s financial health deteriorates. Conversely, if the financial health of a bond issuer improves, bonds purchased 100 euros may trade on the stock market at 105 or even 110 euros.
Example :a corporate bond issued at 100 euros with a coupon of 4% per year may see its price drop to 95 euros if the issuing company is in trouble. The yield will therefore no longer be 4% per year, we will see why later.
The rise and fall of central bank key rates can also impact the price of a bond. Indeed, if the key rate increases, bonds already issued will be less attractive. Conversely, if the rate falls, bonds already issued will be more attractive.
Example : If a central bank’s policy rate increases from 1% to 5%, the bond previously issued with a 3% coupon was competitive and investors were eager to invest at that rate. After the policy rate change, the bond is no longer attractive and investors prefer to invest elsewhere at a 5% rate.
To conclude, throughout the life of a bond, and although the coupon rate will remain the same until the end, the yield on a bond may change due to changes in its price.
So, an investor who buys a 10-year bond (2 years after issuance on the secondary market) at a price of 90 euros and with a coupon of 5% per year will receive 5% of 100 euros each year, i.e., 5 euros x 8 years = 40 euros + the redemption of 100 euros at maturity and not 90 euros. He will therefore receive a total of 140 euros for an investment of 90 euros. (50 x 100 / 90) / 8 = 6.94% annual return.
Of course, an investor who buys a bond that is more expensive than 100 on the secondary market will receive a lower return than the coupon by applying the same logic.
All of this should be well understood by an investor before embarking on an investment in bonds, as significant losses can be incurred in the event of a sale of the securities prior to maturity.
Note, moreover, that the recent increases in key interest rates by virtually every central bank in the world are likely to cause a major stock market crash, as many financial analysts point out. In the event of a crash, it is the prices of bonds already issued that could fall sharply, with recently issued bonds at revised rates expected to be less impacted.
Global bond market figures
At the end of 2021, global debt stood at $226 trillion, or 256% of global GDP (source: Institute of International Finance (IIF). This figure takes into account both household, corporate and government debt. Low or even negative interest rates have pushed governments and private companies to take on debt on a massive scale! Result: the global bond market represents about $127 trillion compared to $87 trillion in 2009 and $115 trillion in 2020.
Global debt has seen the largest increase in the last 50 years
Note: “Market growth was particularly notable in the government debt segment, which accounts for 47% of outstanding bonds,” the IIF report notes. Debt growth has been strongest in emerging markets. For example, China’s debt now represents more than 306% of its GDP compared to 200% 10 years ago.
The financial market impacts of the coronavirus health crisis are also being felt in the bond market. The highest-rated bonds, which act as a safe haven, are the focus of investor attention. The yield on 10-year Treasuries fell to a new all-time low of 0.469%. Its 30-year counterpart fell below the fateful 1% mark for the first time, to 0.9627%. Not only U.S. Treasury yields but also French Treasuries plunge as coronavirus fears push investors to buy back government bonds en masse.
Shares and bonds: what are the differences?
Bonds are debt securities, while stocks are property securities. This is the biggest difference between these two financial products.
By purchasing a share of stock, the investor becomes a partner in a company. This security gives voting rights and/or the right to receive a portion of future profits.
By purchasing a debt security (bond), the investor becomes a creditor of the company (or a government).
Investor: why invest in bonds
The main advantage of being a creditor is that you have priority over shareholders. This means that in the event of bankruptcy, the bondholder will be repaid before the shareholder. However, the creditor has no right to the profits generated by the company when it is in good health. The creditor is only entitled to the principal and interest. It is generally less risky to hold a bond than a stock. In return, the bond often has a lower yield.
An investor may turn to bonds to provide stability to their portfolio. They will also be a risk hedge appreciated by investors with a conservative risk profile.
The bond is therefore often perceived as a safe haven.
It is a long-term investment that provides stable income over time, especially when equity markets are down.
How to invest in a bond ?
There are many, many ways to invest in the bond market, more or less accessible.
Investing in a bond fund
Many types of bond funds exist, accessible directly. But most individuals are present in the bond market via the euro fund of life insurance, mostly invested in bonds, which provides stability and security. It is indeed an investment with guaranteed capital.
Investing in bonds via an ETF
Trackers or ETFs, these index funds that replicate the performance of an underlying asset, are also a way to position yourself in the bond market. Indeed, the 3rd generation of ETFs allows investors to replicate bond market indices, whether sovereign or corporate bonds. A sign of their success: by 2022, bond ETFs accounted for over 38% of the ETF market in Europe.
Investing directly in bonds
This is the least accessible solution, almost out of reach for the retail investor, given the price of a bond and the need to diversify one’s portfolio, which assumes one holds a certain number of them.
However, since 2012, it has been possible for individual investors to invest via an IBO (Initial Bond Offering) and subscribe to bonds of SMEs-ETIs. This offer, centralized by Euronext, allows to position oneself on the corporate bond market of small and medium-sized companies as well as intermediate-sized companies. To do so, simply subscribe online via your stockbroker or by mail sent to your usual financial intermediary.
What are the risks of buying a bond ?
Generally considered to be less risky than investing in stocks, investing in bonds does, however, carry a risk of capital loss. Depending on the strategy for investing in bonds, there can be two main types of risk.
Directly buying a bond to maturity
An investor who buys a bond outright and wishes to hold it to maturity, will really only be exposed to the risk associated with the bankruptcy of the bond issuer company or state.
If the issuer were to go bankrupt during the life of the bond, then the investor may not receive repayment of his or her initial investment and may no longer receive the coupons still due.
On the other hand, if the issuer remains solvent, regardless of rate increases or decreases, regardless of the price at which the bond trades in the secondary market, the investor will continue to receive a return as determined at the time of the security’s issuance and will be repaid on the maturity date.
Note that the investor may suffer a shortfall if rates rise, but no loss of principal.
Investing in bonds via a bond ETF or bond mutual fund
Investing in a bond SICAV or bond ETF exposes the investor to additional risks. This is because most of the time, bond managers do not simply hold the securities until maturity. They often engage in active management with the objective of achieving a higher return on investment.
Thus, managers will buy and sell bonds in the secondary market. A bad investment decision or a change in the macroeconomic environment (such as central banks raising or lowering key interest rates) could result in capital losses, without a bankruptcy of the bond issuer occurring.
It is therefore important to differentiate between the risk of investing in bonds directly and to maturity, with the risks that arise from buying/selling bonds in the secondary market.
Any questions about bonds?
What is a bond?
A bond is a debt security that allows the issuer to secure financing for its debt and the holder to receive interest payments at regular intervals until maturity, when the lender is repaid the face value.
What are the different types of bonds?
There are two main types of bonds: sovereign bonds issued by states and corporate bonds issued by companies. Note: convertible bonds allow the issuing company’s bond to be exchanged for shares, according to a pre-determined conversion parity and during a predetermined period.
What is the yield on a bond?
The yield on a bond depends primarily on the rating given by the rating agency to its issuer. The higher the risk of default and therefore the riskier the bond, the higher the potential yield. Conversely, the better the creditworthiness and therefore the lower the risk of the bond, the lower the yield.
What are the differences between stocks and bonds?
A stock is an ownership security (the shareholder owns a fraction of the company) while a bond is a debt security (the holder is the company’s creditor). While the yield on a stock varies, up or down depending on the company’s profits, the yield on a bond remains fixed. Note also that in the event of bankruptcy, the creditor has priority over the shareholder.
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