A bond is a type of debt instrument. Debt and bonds are also known as fixed income given their structure where the issuer (borrower or debtor) is required to pay to the investor (lender) the amount borrowed plus interest which is based on the interest rate over a predetermined or fixed amount of time. Think about a bond as an IOU.
Bonds generally hold four very specific characteristics:
- Maturity Date: A fixed date when the amount borrowed (principal) is due in full to the investor/lender (person or company who has cash to lend) by the borrower/issuer (person or company looking to access cash).
- Coupon: The coupon is the interest rate that is owed to the investor. This is a contractual amount (interest rate) that is paid to the investor based on a predetermined schedule. After a bond is issued for the first time, the interest rate is referred to as the yield. The yield is the interest rate of a bond based on its supply and demand.
- Coupon Period: The coupon period determines when interest payments are due, for instance, every six months (semi-annual), annual, or perhaps at maturity.
- Par Value: The par value of a bond determines the original price of the bond. Because bonds are investment products that can be traded, the price of a bond fluctuates to reflect the trading activity. Par value is also known as Face Value.
Types of Bonds
The United States (U.S.) bond or fixed income market is the largest in the world and is made up of many different types of bonds, issued and traded by both local and foreign governments and corporations worldwide. Many countries have their own national bond markets, such as China and Japan, who after the U.S. have the second and third largest bond markets. The Eurobond market is another bond market that holds a high market share and national governments globally. Across all of these markets, most bonds will fall within one of the following types:
- U.S. Treasury Securities: Bonds issued by the U.S. Government. These bonds are backed by the full faith and credit of the United States Government. These bonds are viewed as being the safest and of highest quality and perceived to have no risk. These include Zero Coupon bonds that do not pay interest and instead you purchase the bond at a discount and receive the interest at maturity.
- U.S. Agency Securities: Bonds issued by U.S. Government agencies, such as the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC).
- Municipal Securities: Bonds issued by state and local governments to raise money for projects. These bonds are generally tax-exempt (not taxed), and generally fall under one of two classifications:
- General Obligation Bonds (GO): Are bonds that are secured by the issuer’s unlimited taxing power in order to fund projects to maintain public facilities, such as schools, libraries, and parks. These are generally projects that are not privately funded.
- Revenue Bonds: Are bonds that are generally issued in order to raise money for a project, such as constructing a new airport, hospitals, colleges, and roads.
- Corporate Bonds: Are bonds issued by corporations that are headquartered anywhere around the world. These bonds are generally taxed as ordinary interest income and generally fall under one of two classifications:
- Domestic: Bonds issued by U.S. corporations. These bonds include debt issued by corporations, such as Microsoft, Facebook, General Motors, and Apple to further expand their company by borrowing money, using their current assets as a pledge (collateral) of their strength and stability, and more importantly their ability to pay back the loans (bonds).
- Yankee: Foreign bonds usually registered with the SEC, denominated in U.S. dollars, and issued in the United States by foreign banks and corporations. For example, bonds issued by Japanese organizations are called Samurai bonds.
Globalization has broadened the ability for companies, governments, and individuals to lend extra money to individuals, companies, and governments around the world through the use of bonds, without having to physically leave your geographic location.
Primary dealers are banks and broker-dealers who have received approval to trade directly with governments and central banks with regard to treasury securities – bonds issued directly by the government. In the U.S., a list of primary dealers is published by the Federal Reserve Bank of New York.
In order to become eligible as a primary dealer, banks and broker-dealers must:
- Be a bank or broker-dealer that is supervised by the Securities and Exchange Commission (SEC) and approved as a member of the Financial Industry Regulatory Authority, Inc., (FINRA);
- Meet capital requirements based on regulatory guidelines;
- Hold and maintain market share within the Treasury securities markets of at least one quarter of one percent while consistently bidding (buying) on new auctions for Treasury securities;
- Take into account market volatility and other risk factors;
- Back up or contingency plans with other market participants in the event the original arrangements fail;
- Operational and financial capacity to collateralize assets in order to increase leverage if necessary;
- Must be an active participant in the clearing system to allow for delivery of cash and bonds for settlement;
- Have disaster recovery capabilities, reflected in their Business Continuity Plans (BCPs) and routinely tested that can withstand a severe business disruption by employing geographic dispersion between primary and secondary locations. This step requires coordination with other existing primary dealers to ensure arrangements are in place in case of a catastrophic event.
After a bank or broker-dealer becomes eligible as a primary dealer, they are added to a list that provides to the public the names of financial institutions who are authorized to buy and sell the debt securities that are created by the government.
There are 24 Primary Dealers that are responsible for all of the bonds issued through the U.S. Globally, some of these dealers include:
- Barclays Capital Inc.; headquartered in London, England, United Kingdom.
- Bank of America Securities, Inc.; headquartered in Charlotte, North Carolina, U.S.
- Citigroup Global Markets Inc.; headquartered across regions in U.S., Western Europe, Hong Kong, Japan, and Singapore.
- Credit Suisse AG; headquartered in Zurich, Switzerland.
- HSBC Securities (USA) Inc.; headquartered in Hong Kong.
The full list of primary dealers is available directly through the New York Federal Reserve (a link is located in the Materials & Resources section).
If a company wants to raise money for a project without having to sell an asset, it will use bonds as an instrument to borrow or raise money. Companies are defined as corporations, hence the name corporate debt, which represent both public and private companies who also serve as the borrower or issuer of the bonds.
Unlike government issued bonds that when created are only purchased by a predetermined list of primary dealers, companies that issue bonds begin with their bank to determine the company’s ability to service or pay interest on the bond through its stated maturity.
Under the guidance of the bank, after conditions, legal considerations, and parameters are in place, companies then proceed to the next steps of trying to locate qualified investors – known as the Roadshow.
Roadshows provide companies the opportunity to convince qualified investors why they should lend their money for the operation, and also for the company, to determine risk appetite from investors and their willingness to lend during a particular market environment.
Under extreme economic uncertainty the federal government may step in as a market participant to buy bonds from companies, in order to prevent a severe recession or depression.
After a bond has been issued, its value is then determined based on supply and demand. This process is completed within what is called the secondary markets.
Secondary markets are where a majority of investors buy and sell bonds and stocks. In the secondary market, securities are sold by and transferred from one investor to another. Basically, secondary markets mesh the investor’s preference for liquidity with the capital user’s preference to be able to use the capital for an extended period of time. For example, an investor may not want to tie up his or her money for a long period of time, in case the investor needs it to deal with unforeseen circumstances and needs to sell bonds and stocks on the secondary markets.
Secondary Exchange Markets include:
- New York Stock Exchange – The NYSE is famously known for stock trading; however, it is the largest exchange for bond trading.
- Nasdaq Stock Exchange – based in New York, it is ranked second behind NYSE
- London Stock Exchange – is the oldest stock exchange in the world
- Over the Counter – OTC transactions occur without the involvement of an exchange, where the buyer and seller of a bond are matched directly through a dealer.
Bonds have many risks associated with them as investment instruments. So, let’s go over the most common risks investors are exposed to when choosing to lend money with the expectation of getting it back sometime in the future.
- Call Risk: A provision that allows the issuer to retire or “call” all or a part of the bond before the maturity date.
- Default Risk: Also known as credit risk, refers to the risk that the issuer of a bond may default on the original terms of the bond agreement, and be unable to make timely payments on interest and principal.
- Interest Rate Risk: Also known as market risk. The fact that bond prices will change in value after the issue date because they are driven by the supply and demand of the bond. Bond prices typically move in the opposite direction from a change in interest rates: As interest rates rise, the bond price will fall and vice versa if the interest rate falls, the bond price will rise.
For example, if an investor sees the price of their bond falling with interest rates increasing they may decide to sell if they can earn a higher interest rate on another bond. In selling a bond below the original face value (par value) the investor will have a capital loss. If an investor believes that they will receive all of their money based on the stated loan maturity and are satisfied with the interest rate they are being paid, by holding the bond until maturity this risk can be avoided, but of course depending on many characteristics and provisions of the bond.
- Reinvestment Risk: This is the risk that the interest rate at which cash can be reinvested will fall, which would lead to investors earning a lower interest rate on their cash over a longer period of time.
NOTE: A very important note to always remember is that Interest Rate Risk and Reinvestment Risk offset each other. Interest-rate risk is the risk that interest rates will rise, thereby reducing a bond’s price. In contrast, reinvestment risk is the risk that interest rates will fall.
- Volatility Risk: Bonds with certain types of features such as multiple interest rates and variables that have an affect on the value of the bond may be susceptible to additional fluctuations in value which is called volatility risk.
- Inflation Risk: Also known as purchasing-power risk presents itself if the rate of inflation is higher than the interest rate an investor would receive on a bond. For example, if an investor purchased a bond paying an interest rate of 5% and the rate of inflation was 8%, the investors purchasing power on that cash flow (cash being invested) would be negative 3%.
- Exchange Rate Risk: Also known as currency risk. This risk is only for investors who exchange their money from one currency to another. (i.e. U.S. dollar to Pesos). A non-dollar-denominated bond (a bond whose payments occur in a foreign currency). An investor would have no idea of how many U.S. dollars the issuer (borrower) has available to make the interest payments in U.S. dollars.
For example, an investor purchases a bond whose payments are in Japanese yen. If the yen goes down in price relative to the U.S. dollar when the American investor exchanges the yen to U.S. dollars they will then receive fewer dollars.
- Liquidity Risk: Also known as marketability risk which depends on how easy it is to sell and buy the bond after its been issued at or around the price it was originally issued. One way to determine what the risk of a bond is would be to look at the difference between the bid price (maximum price the buyer is willing to pay) and the ask price (lowest price the seller is willing to accept). The bigger the difference between these two prices on the same bond will indicate a higher level of liquidity risk, vice versa, if the difference between the bid price and the ask price is small, there would be lower liquidity risk.
Now that you have a better understanding of types of bonds and their risks, let’s take a look at third party rating systems to determine what type of bond you may want to invest in.
Deciding where to lend your money as an investor can be a challenging decision. Investors use many different techniques to research information on bond issuers (borrowers) in order to make an educated decision on the borrowers ability to follow through on all of the provisions (details) on the bond and pay back the investment with interest.
Many professional money managers who invest in bonds using money that belongs to their clients will have a team of people who are dedicated to collecting information on different types of bonds. However; most individual and professional bond investors will rely on companies that perform bond analysis and share their opinions, thoughts, and concerns using a system of ratings.
These companies are known as commercial rating companies. In the United States (U.S.) there are three commercial rating companies that are widely used by most investors: Fitch Ratings,
Standards & Poors (S&P) Ratings, and Moody’s Investor Services. Each one has their own letter-based ratings scale to quickly convey to investors whether a bond carries a low or high default risk and whether the issue is financially stable.
Let’s look at one of the rating companies’ scale as an example. Fitch has been providing bond ratings for over 100 years across bond markets globally. Their ratings scales are based on:
- Issuer Default Ratings: Issuer default ratings range from AAA to D being the worst. AAA ratings denote the lowest expectation of default risk. They are assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.
- National Long-Term Credit Ratings: National Long-term credit ratings range from AAA to D being the worst. AAA National Ratings denote the highest rating assigned by the agency in its National Rating scale for that country. This rating is assigned to issuers or obligations with the lowest expectation of default risk relative to all other issuers or obligations in the same country or monetary union.
- National Short-Term Credit Ratings: National Short-term credit ratings range from F1 to D being the worst. Where the liquidity profile is particularly strong, a “+” is added to the assigned rating. F1 Indicates the strongest capacity for timely payment of financial commitments relative to other issuers or obligations in the same country. Under the agency’s National Rating scale, this rating is assigned to the lowest default risk relative to others in the same country or monetary union.
- Recovery Ratings: Recover Ratings range from RR1 to RR6 being the worst. RR1 rated securities have characteristics consistent with securities historically recovering 91%–100% of current principal and related interest.
- Bank Viability Ratings: Bank viability ratings range from AAA to F being the worst. AAA ratings denote the best prospects for ongoing viability and lowest expectation of failure risk. They are assigned only to banks with extremely strong and stable fundamental characteristics, such that they are most unlikely to have to rely on extraordinary support to avoid default. This capacity is highly unlikely to be adversely affected by foreseeable events.
Commercial rating companies provide rating scales to allow for investors to make good decisions with their money by determining the quality of a bond based on comparisons to other bonds in the market. However, commercial rating companies do not have any influence on the types of bonds that are issued. In other words, if risky businesses are borrowing money to in turn make risky investments in their company, this could be a sign of economic and market conditions based on the business cycle over the ratings scale.
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