Bonds

A bond is a type of debt instrument issued and sold by a government, local authority or company to raise money. Investors who buy bonds are paid interest, which for bonds is called a “coupon”.

The entity borrows the funds for a predetermined amount of time over which interest must be paid. At maturity, there is a final interest payment and return of principal. The interest rate is determined by the size of the coupon and the price of the bond at purchase. If the bond is held to maturity, it also represents the rate of return on the investment.

Bonds are normally issued at par values of $100 or $1,000. Its actual market price will be dependent on some combination of its duration or time until maturity, credit quality, coupon rate, and the future anticipated direction of interest rates.

The borrowed funds are typically used for capital investment projects and to fund operational and/or financial activities, such as inventory needs or to refinance current debt. Bond purchasers are commonly referred to as debtholders or creditors.

Most corporate and government bonds are traded on public exchanges. Some, however, are traded on over-the-counter markets, where buyers and dealers exchange securities without regulatory oversight from an exchange.

Types of Bonds

Fixed-rate bonds – The most common type of bond, with a coupon that remains fixed throughout the life of the bond. Bond coupons can also escalate in value throughout the life of the bond. This extends its duration, given it pushes more of the cash flow to be paid out at a later date, and increases its interest rate risk.

Zero-coupon bonds – Pays no interest, but generally issued at a discount to par value (the extent of such depends on a similarly priced coupon bond), with price appreciation common leading up to expiration. The full principal amount is paid at maturity. Zero-coupon bonds, both fixed-rate and inflation-protected, are issued by the US government. These are typically called “strips”, as the coupons are stripped out and can be traded separately from the bond itself. Given the higher duration of these bonds, they are more volatile than regular coupon bonds.

Floating rate or inflation-indexed bonds – Bonds tied to some reference rate, such as a specific LIBOR rate plus a spread, or tied to a measure of domestic inflation. Inflation and interest rate volatility are two common risks associated with fixed-rate bonds. To account for this, some offerings will provide protection against these risks by offering floating (or variable) rate bonds. Coupon rates are typically recalculated every 1-12 months. The UK was the first government to issue inflation-indexed bonds in the 1980s. The US issued its own inflation-protected securities (“TIPS”) beginning in 1997.

High-yield bonds – Also known as “junk bonds”. This distinction includes bonds with a credit rating below BBB- on the S&P and Fitch scale and Baa3 on the Moody’s scale. The credit quality of these bonds is lower due to higher levels of financial risk that raises the issuer’s risk of insolvency. Investors expect to be compensated for taking on higher risk. Therefore these bonds are considered to be “high yield” relative to an investment-grade bond.

Municipal bonds – Bonds issued by a city, state, province, or other local government. Individuals are often incentivized to invest in municipal bonds through their tax-free structures. (However, this is not always true and depends on the jurisdiction.)

Convertible bonds – Under certain conditions, a debtholder can convert a bond to a certain number of shares of the issuer’s common stock. Because they combine debt and equity characteristics, they are considered hybrid securities.

Indexed bonds – Bonds linked to a certain business indicator (i.e., net income) or macroeconomic statistic (e.g., GDP). This structure is chosen for companies that want to have greater control over their cash flow by matching business performance with the payout of its bonds. Some municipal bonds, known as revenue bonds, are indexed to the revenue generated from the project the bond proceeds funded.

Asset-backed securities (ABS) – Fixed-income instruments where interest and principal payments are secured by the cash flows of other assets. These can include mortgage-backed securities (MBS), collateralized debt obligations (CDOs), student loans, credit card receivables, airplane leases, among various other assets. The individual components to ABS are illiquid and generally infeasible to sell individually, hence the need for securitization.

Investors look at ABS as an alternative source of fixed-income investment and diversification. Assets are pooled and no single asset is generally responsible for having an outsized impact on its valuation. Issuers often lean toward the ABS structure because the process of securitization allows them to move the underlying assets off their balance sheets and transfer the accompanying risk to a counterparty (the investor).

Covered bonds – Bonds backed public or private assets, such as mortgages. Covered bonds differ from ABS in that the assets stay on the issuer’s balance sheet.

Climate or green bonds – Bonds issued by governments or corporations to raise funds for climate change mitigations or environmental preservation initiatives.

Mezzanine debt – Bonds, loan debt, or preferred stock that represents a claim on the company’s assets, only senior to that of common shares. In the case of a bankruptcy scenario, creditors to the company are paid back based on their hierarchy in the capital structure.

Holders of senior debt secured by a claim to assets of the company will be first in line, followed by junior/subordinated debt holders, followed by preferred stockholders, and finally those holding common stock. Because of this payout hierarchy, senior debt will have lower returns expectations relative to capital subordinated to it, with common shares having the highest returns expectations, holding all else equal.

In the case of ABS, where different assets are packaged and pooled into a single security, in the event of default of some securities, the ABS itself should still retain value, with senior tranches paid back before subordinated tranches.

Perpetual bonds – Bonds with no maturity date. Also known as perpetuities. These bonds issue coupon payments at regular intervals (normally every 6 or 12 months) and will do so into perpetuity. Some bonds that mature 100+ years in the future may also be labeled “perpetual” given their very long-term nature.

Government bonds – Bonds issued by a central government in developed markets are often termed “risk free” given they are backed by the credit of the government. Given the normally solid credit stature of these bonds, interest is generally lowest on these relative to other fixed income instruments. Moreover, given government agencies in developed economies run on fiat currency systems (i.e., not backed by a commodity generally considered of value, and has value by government decree), it is always expected that governments can pay their debt in nominal terms to avoid default if necessary, though potentially at the expense of inflation.

Callable bonds – Bonds that the issuer can call back from debtholders if interest rates fall to some stipulated extent. This is done under the premise that cheaper financing can be obtained in lieu of the more expensive bonds currently on the market. This gives issuers greater control over financing costs. However, investors will generally demand extra compensation for these due to the risk associated with these bonds being called.

Putable bonds – Bonds that can be put back to the issuer if interest rates rise to some degree. This limits interest rate risk on behalf of the investor. For the issuer, since they assume more interest rate risk, putable bonds are generally a cheaper source of financing.

Bond Trading for Day Traders

For day traders, the most convenient way to trade bonds is through their exchange-traded fund (ETF) equivalents. Bond ETFs follow an index that underlies the security and trades as an equity product.

These securities tend to be liquid and thus amenable for those pursuing an active trading style. Typical bond markets tend to be fairly illiquid or have high capital requirements in order to participate, which makes them non-ideal or off-limits for many traders.

These days, there is an ETF for all the main types of bonds – government, corporate, municipal, short-/medium-/long duration, investment grade, non-investment grade, emerging markets, developed markets, interest rate hedged, convertible, inflation-linked, variable rate, and mostly everything in between.

ETF trading is available at virtually all brokers that specialize in stocks trading.

Main Risks

There are two main risks to bonds: credit risk and interest rate risk.

Credit Risk

Credit risk is derived from the potential that a bond issuer will not have the financial means to make principal and interest payment. Issuers, whether they be governments, corporate entities, or municipalities, are generally rated on their credit quality by assessing their cash flow metrics (and their stability) against their debt load.

Interest Rate Risk

Interest rate risk boils down into two subcomponents: duration and convexity.

Duration is the amount of time it takes to reach breakeven on a fixed-income investment. The longer a bond’s duration, the greater its interest rate risk. Yields are inversely related to fixed-income bond prices. So as yields rise, prices decrease.

A better measure of interest rate risk, however, is convexity. Convexity is a measure of how duration changes with respect to changes in interest rates. Duration, as a risk management tool, operates under the assumption that changes in interest rates and bond yields is linear. In reality, the relationship is non-linear and best illustrated by convexity. The more curved the relationship between price and interest rate changes, the more inaccurate duration becomes as a risk measure.

Mathematically, duration is the first derivative of a bond’s price relative to interest rates. Convexity is the second derivative with respect to how a bond’s price changes relative to interest rates, or the first derivative with respect to how a bond’s duration changes relative to interest rates.

In the diagram below, duration shows the inverse relationship between price and yield. Bond B is more convex than Bond A. This means that Bond B is more volatile than Bond A, given a smaller change in interest rates will impact its price to a greater extent.

bonds

What makes a bond have higher convexity?

All of the following are associated with higher convexity:

  • Lower coupon payment
  • Longer time to maturity
  • Lower credit rating/higher credit risk

For speculators looking to make higher returns or have a clearer opinion on the future direction of interest rates, bonds with higher convexity and/or duration may be appropriate.

For those looking to achieve stable cash flow from bonds over the long-run, bonds with lower convexity and duration may be the better option.