Investment in bonds is the most reliable investment in the securities market. This tool is recommended for those who are interested in the complete safety of capital with an income slightly higher than for a deposit in a bank.
The bondholder receives a fixed interest income from his investment. In addition, in many cases bonds are sold at a price below par (at a discount), and they are redeemed by the borrower at par. The difference between the purchase price and the nominal value is also the investor’s income.
This tool is very similar to a bank deposit – money is invested in it for a certain period at a previously known percentage. But bonds have two main advantages: as a rule, a higher yield on corporate bond issues and the ability to withdraw money without losing the accrued interest. If at early closure of a fixed-term bank account, interest is lost, then investments in bonds are completely liquid – they can always be sold without losing the interest due for each day the bond is held.
The bond market is a market for conservative investors (as opposed to the stock market). Price fluctuations in this market are incomparably small compared with the active dynamics of stock price. For investors, the main thing is interest (coupon payments), although a change in the market value of a bond also affects profitability. Corporate bonds are more reliable than stocks and more profitable than bank deposits.
The yield of corporate bonds ranges from 8 to 18%, depending on the reliability of the issuer of the bonds. There is a wide variety of bond issues on the market, from which an investor can choose the best combination of profitability and risk. There are bonds of reliable, large companies with small coupon payments, there are also “junk” bonds of medium-sized enterprises with high interest payments. The yield on bonds of new small issuers, which for the first time bring their securities to the market for the first time, is especially high.
Government bonds of the Russian Federation (OFZ) are not of interest to the mass investor due to their low yield (about 8% per annum).
Bond – debt security. Having bought the bond of the issuing company, the investor becomes its lender. The issuer undertakes to pay the holder of the bond at the end of its circulation period the nominal value of the bond and the previously known or easily predictable stable income as a percentage of the nominal value.
Bonds are issued by companies of various industries, as well as banks. In 2004, more than 80 companies and banks issued their bonds. Among them were both high-quality and less reliable issuers.
Bonds can be sold on any day or you can wait for the maturity date of the bond by the issuer (the term of the bond is 3-5 years). The accrued coupon income and face value of the bonds are transferred to the investor’s account opened with the broker.
The main trades in bonds are conducted in the MICEX Stock Market Section. You can buy bonds in the same way as stocks, via the Internet. All major stock exchange data for each bond issue are transmitted to bidders and are available through trading terminals. However, in order to buy bonds, it is not necessary to install a trading terminal and make deals with bonds via the Internet. A broker will be able to buy bonds for you if you give an order by phone.
Key indicators for assessing bonds
Bonds, as a rule, are considered to be a safer investment instrument than stocks, since their owners have a priority in claiming a share of the company’s assets in the event of its liquidation or restructuring. For issuers, bonds are a reliable alternative to banks and other lenders who may offer less attractive financial conditions than capital markets: for example, higher interest rates on loans.
In the process of investing in bonds, you need to pay attention to a number of key indicators, including maturity, early repurchase conditions, credit quality, interest rates, price, profitability and tax status. Together, these factors allow the investor to assess the real value of specific debt obligations and decide to what extent this type of investment corresponds to its investment objectives.
Maturity. The maturity term means the predetermined date in the future for which the nominal value of the bond should be returned to the investor. The maturities of bonds typically range from one year to 30 years. Maturity ranges are classified as follows:
- Short-term: – up to 5 years;
- Medium-term: – from 5 to 12 years;
- Long-term: – from 12 years and above.
Some bonds have a clause on early repayment, or “revocation” (redemption provisions, call provisions), which allows the issuer (or obliges it) to redeem them from investors before maturity, at a predetermined date, while paying their nominal value. Issuers of bonds sell bonds with the right of early redemption, or recall (callables), in order to ensure their relative freedom of action, while retaining the right to repurchase bonds before the maturity date after a predetermined date. This right is essential for bond issuers in the face of falling interest rates, since it allows them, by withdrawing existing debt obligations, to issue new ones – by the same amount, but at a lower interest rate.
In the case of a “withdrawal” of bonds, the nominal amount of debt in cash is returned to investors, after which they are given a much less attractive opportunity to reinvest in more expensive instruments with lower returns. This risk is called the risk of reinvestment. Investors who want to avoid this risk may purchase irrevocable bonds (bullets) with a fixed maturity date, which is issued at a time, for which there is no possibility of early withdrawal from circulation. The yield of this type of paper is usually lower than that of bonds with the right of revocation, but the issuer cannot force bondholders to repay them before the deadline, regardless of changes in interest rates.
There are so-called bonds with a put option (put bond), which, on the contrary, give the investor the right to demand from the issuer that he redeem his securities at a certain date before the maturity date. Investors typically use this right when they need cash or when interest rates rise significantly compared to the level at which they were at the time of issuing bonds. In this case, bondholders can re-invest the money received in securities with a higher interest rate.
Before buying bonds, the investor must find out whether the terms of sale include the early redemption clause and, if available, make sure that he will receive income calculated on the first possible early repayment date, and not just the income at the maturity date. Bonds sold with an early redemption clause usually generate a higher annual yield to offset the risk associated with the possibility of premature withdrawal from circulation.
Interest rates. Bonds bring investors interest income, which can be fixed, “floating” or paid at maturity. For most debt obligations, the interest rate is set, which remains at the same level until maturity and is calculated as a percentage of the nominal value of the security (fixed rate). As a rule, bondholders receive interest payments once every six months. For example, a bond owner worth $ 1,000 at a rate of 8% will receive $ 80 per year – at $ 40 every 6 months. When the maturity of the bond comes, the investor will receive an amount equal to its face value – $ 1000.
Some investors prefer securities for which the interest rate can be adjusted and to a greater extent reflects current levels of market rates. There are so-called “floating rate” bonds, which are periodically adjusted to reflect changes in base interest rates, such as treasury bill rates.
In addition, there are papers, so-called “zero-coupon bonds” (zero-coupon bonds), which, unlike ordinary bonds, do not imply regular interest payments. Instead, these bonds are sold at a significant discount to face value.
There are 3 basic types of zero-coupon bonds in the US bond market: zero-coupon treasury bonds, zero-coupon corporate bonds and zero-coupon municipal bonds. Zero-coupon treasury bonds are generally considered the least risky of the three types of securities, as they are fully guaranteed by the federal government. Zero-coupon corporate bonds offer a potentially higher rate of return, designed to compensate for additional risk, the scale of which varies from one issuer to another.
Credit quality. Bonds can have very different credit quality: from treasury bonds, fully guaranteed by the US government, to bonds with a rating below investment grade, which are considered as speculative. When issuing bonds, the issuer is obliged to provide detailed information on its financial position and solvency. This information is contained in the prospectus, but on its basis it is difficult to conclude whether the company or government agency will be able to pay regular interest payments 5, 10, 20 or 30 years after the emission. Rating agencies come to the rescue, which assign a credit rating to many bonds during the issue and then track them during their “life cycle”. Brokerage firms and banks also have a staff of analysts,
Leading rating agencies are Moody’s Investors Service, Standard & Poor’s Corporation and Fitch. Each agency assigns ratings to bonds based on its own system, based on a deep analysis of the issuer’s financial position, management quality, economic factors and specific sources of income that guarantee payments on bonds. The highest ratings are “AAA” (S & P and Fitch) and Aaa (Moody’s). Bonds rated BBB or above are considered investment grade bonds; bonds rated BB or lower are considered to be high-yield bonds, or bonds below investment grade. Although experience shows that a diversified portfolio of high-yield bonds in the long run carries a very small risk of default,
As a rule, agencies signal that they are considering the issue of changing the rating of bonds, placing them on a list of especially carefully monitored securities: CreditWatch (S & P), Under Review (Moody’s) or Rating Watch (Fitch).
Bond insurance. Credit quality can be improved by insuring a bond. Specialized insurance companies that serve the fixed-income market guarantee investors timely payment of principal and interest on the bonds insured by them. In the US, the largest bond insurance firms are MBIA, AMBAC, FGIC and FSA. Most of these companies have at least one credit rating out of three “A”, assigned by a nationwide rating agency. The insured bonds, in turn, acquire the same rating based on the size of the insurer’s capital and its resources intended to pay the money on demand. Historically, such activities have been concentrated in the field of municipal bonds, but bond insurers also provide guarantees for obligations
Tax status. Some types of bonds provide investors with tax advantages. Thus, interest paid on US Treasury bonds is not subject to state and local government taxes; interest on most municipal obligations is not subject to federal taxation and, in many cases, also local income tax. An investor usually prefers to receive taxable income or, conversely, income from which no taxes are levied, depending on the level of the tax scale to which his income belongs, and also on the difference between profits from taxable and tax-exempt bonds (not just for now). , but for the entire period to maturity). The decision to invest in taxable or tax-free bonds also depends on
Price. The price of a bond is based on a large number of variables, including interest rates, supply and demand, credit quality, maturity and tax status. Bonds of new issues are usually sold at or near their nominal value. The prices of bonds traded on the secondary market fluctuate in response to changes in interest rates. If the price of the bond exceeds the nominal value, then they say that the bond is sold at a premium; if the price is lower than the nominal value, they say that the bond is sold at a discount. Treasury bonds, which are initially placed through auction trading, are sold at a discount to face value, and they are redeemed at face value.
Nominal income. Nominal yield is a fixed income determined by the interest rate established for a given bond at issue. It is also called a coupon rate. If the bond has a cost of $ 1000, and the coupon rate is 10%, then the investor will receive interest in the amount of $ 100 per year, which will be paid every six months for $ 50.
Yield. When investing in bonds, it is important to remember that the profitability of investments is associated with risk. The more risky a bond is, the higher its yield, as a rule, is, since it is designed to reward the investor for taking the risk.
The current yield is calculated by dividing the annual coupon yield by the current market price of the bond. For example, if the current price is $ 1000 and the coupon rate is 8% ($ 80 per year), the current yield is 8% ($ 80 divided by $ 1000 and multiplied by 100%). If the bond is trading at $ 900, and the coupon rate is also 8% ($ 80 per year), then the current yield is already 8.89% ($ 80 divided by $ 900 and multiplied by 100%). The current yield on discount securities is calculated by dividing the discount by the difference between the nominal value and the discount.
Yield to maturity (yield to maturity) or yield to early repayment (yield to call) are considered more important indicators than the current yield, and provide an opportunity to compare bonds with different maturities and coupons. The difference in yields of two bonds is usually called the yield spread. Essentially, the yield to maturity is a discount rate at which the future returns on the bond will be equivalent to the current price.
When calculating the yield to maturity, the sum of all interest payments received by the investor from the moment of buying the paper to the maturity is taken into account, as well as a discount (in the case of buying a bond below par) or a premium (in the case of buying above par). Bond yield to maturity gives an idea of the real value of securities for the investment portfolio and therefore is one of the most important indicators that must be considered when making decisions about the purchase of bonds.