Bonds: a quick overview
Bonds are contractual debt instruments between a borrower (the debtor) and a lender (the creditor). There are usually 5 key characteristics of a bond:
• Principal amount - the total amount borrowed by the debtor from the creditor.
• Coupon rate - the interest rate paid on the principal by the debtor to the creditor.
• Coupon interval - the frequency at which the coupon will be paid. Normally it is quarterly.
• Duration - the length of the bond. The principal will need to be repaid at the end of the duration.
• Collateral - debtor’s assets pledged to creditors as security on the loan, in case of default.
Just like stock investors, bond investors make money in 2 forms: income and capital gains. However, the mechanisms of how these 2 types of gains come into play are very different.
Unlike dividend (which is a payout from the profit a company makes to its shareholders), which can be variable and unpredictable, coupon (interest) on bonds that are paid out to bondholders is fixed and must be met no matter the circumstances. Failure to observe such a covenant would be treated as a default, which carries a significant penalty, not least the ability of bondholders to institute insolvency proceedings against the borrower.
The way how capital gains works in a bond is also different. Unlike stocks, where the price is based on discounting future earnings expectations into the present day, the principal bond amount (nominal value) should stay, theoretically at least, the same from issuance to maturity. If the par value is $100 at issuance, then at the end of the duration (e.g. in 20 years), investors should still get paid $100. Yet there are 2 factors which affect the price of bonds (assuming it is being publicly traded):
• Risk-free return offered by alternative assets: due to the time value of money, where $100 in 20 years will be worth far less than $100 today (due to inflation and the cost of delayed gratification), investors are faced with alternatives when investing in fixed income assets. For example, when the base rate for bank deposits (which is considered to be risk-free) goes up, it makes deposits relatively more attractive than before, when compared to bonds. As a result, the demand for bonds will shift away (in magnitude proportional to the extent of the rise in the rate) towards deposit; thus causing a fall in bond prices.
• Credit risk of the borrower: if a borrower could not pay back the principal at the end of the loan period (or it could not pay the coupon during that period), then the borrower would have defaulted on the bond. This degrades the creditworthiness of the borrower and makes it significantly more risky, thereby decreasing the attractiveness of its debt and hence leading to a decline in its bond price.