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Friday
Mar 22nd
Home arrow Money arrow Bonds

Bonds

In our last column, we mentioned that savings certificates are IOUs issued by a bank.  Strictly speaking they are a form of bond. But bonds are much older than that. The bond was born the first time a monarch borrowed a large sum of money from a rich neighbour, agreed to repay the money with interest, and wrote this up on a piece of papyrus, the bond was born. Deficit-laden governments use bonds to finance their budgets, cash-strapped companies sell debt in order to get the money they need to expand.

Bonds are a form of debt that is sold to the public in multiples of €1,000. The lender gets a piece of paper that stipulates how much was lent, the agreed interest rate, how often interest will be paid, and the duration of the loan.  There are different forms of bonds, depending on the issuer. Different issuers have different ratings, depending on their credit-worthiness. The better the rating (e.g. AAA), the smaller the credit risk … and the lower the interest rate.  Ratings are given by independent bureaus like Moodys or Standard & Poor’s.

The issuer can be a government (treasury bonds or bills) or a government agency. These are usually backed by the government, so that the risk is limited.  In fact the government can print more money if it needs to.

Companies issue corporate bonds just like they sell stock. Companies have quite a lot of leeway to issue bonds; still they must make them attractive to be able to sell them. One of these marketing techniques is to issue convertible bonds, which can be converted into stock if certain conditions are met.  Because of the risk that the company may default on the bond, it will have to offer a higher interest rate. If the credit quality of the company is below investment grade, Moody’s calls it speculative grade; we call them ‘junk bonds’.

To compare bonds, you need to look at their par value, coupon rate, and maturity date.

Par value is the capital mentioned on the bond. That is the amount of money the investor will receive when the bond matures. The issuer will return to the investor the original amount that it was loaned (e.g. € 1,000). However, that is not always the price you pay for the bond as we will see.

The maturity date is when the bond issuer must pay back the capital borrowed. That ends the obligation to pay interest. Sometimes corporate bonds can be ‘called’, or paid back well before the maturity date.

The coupon rate is the percentage of the par value that will be paid out as interest. The interest is usually paid every year, but it may be monthly or quarterly. To calculate the return of a bond, you cannot just look at the coupon rate; you must divide the annual interest by the current price of the bond.  

That is because bond prices fluctuate as interest rates change. If the interest rates are higher than the coupon rate, you will expect to pay less for the bond and you buy under par (e.g. 800). And if you own a bond with a higher than normal interest rate, you would be able to sell above par (e.g. 1,200). If you hold a bond to maturity, you will get back the capital. If you buy or sell bonds before they mature, you can make or lose money depending on the maturity date, the current interest rates and the transaction costs involved.

Zero-coupon bonds are a type of bond that pays no interest until the maturity date. At maturity you the capital back plus interest for the duration of the bond.

In the next column, we will look at how you buy bonds, the transaction costs and the taxes.

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