08^th January, 2021 by elmads

✍️ Edited: 03^rd September 2023

Introduction

All that we need is interrelated with money, such as transportation, food, and shelter. Even when we start a small business, we still need money. The problem that arises is: how do we finance ourselves to venture into this kind of business endeavour?

There are two basic ways in which we could finance a start-up: either by utilising our saved money or by going into debt. Debt itself is a financing tool, not only used by average individuals like us but also by large corporations and governments.

It is known to everyone that both of these institutions have a large sum of money, but just like other resources, the money they have is also finite. This is the reason why they also go into debt in order to finance their current and future goals.

For companies, they use debt usually for business expansion and growth, while for the government, they use debt by building infrastructure to spur the growth of the economy and the country they govern.

The long-term debt they incur is known as a bond, which is a document that signifies that a person, a group of persons, or an entity lends their money to these institutions in the expectation of a fixed interest rate payment called a coupon for a certain period of time.

The governments and corporations that are in debt now have an “I Owe U” promise to the investors who lent them money. These investors are now called debt holders, or creditors.

Advent of Bonds

Some of you might be wondering how bonds came to life. The first documented event in history where it was said that bonds started was traced back to 14th-century Italy, which is also the place where banks were born. During those times, wars for power and glory were raging within the states of Italy. The kings of that time needed money to finance their war efforts, such as food and armouries, and also to pay for mercenaries. Yes, they did use mercenaries as their subjects because they did not want to greatly reduce the number of men in their state just for the war.

What the kings did before was increase taxes plus the mandatory “I Owe You” bonds. In this case, their citizens were forced to give them money in exchange for an interest payment. The monarchy also allowed their citizens who owned the IOU documents to trade them to other citizens. This is how bonds and the bond markets were born.

The Characteristics of A Bond

• Par Value – this has various synonymous names like Principal, Face Value and Initial invested amount. As the name states, it is the initial price at which we are able to purchase the bond at the time it is issued.
• Term – also known as maturity. It is the number of years in which the company or government is obligated to pay us interest. At the end of the term contract, the institution will give back the initial capital we gave them, which in turn means that their debt obligations to investors are now complete. Term periods have three categories: short-, medium-, and long-term maturities.
• Coupon Rate – This is the interest rate that companies and governments will be paying to their bond holders. It is a fixed rate amount that is being paid either quarterly, biannually, or annually, depending on the bond contract.

📝 NOTE: All three terms I discussed are determined by banks. That is because banks are the ones who make and issue bonds.

You will also encounter terms such as Notes and Bills. They have similar features as bonds, the only difference is their maturity. Bonds have a term of more than 10 years, whereas Notes and Bills matures less than 10 years.

The coupon payment is the amount of money you’ll be receiving on a bond. In the illustration above, the coupon payment is not stated. We can compute it by multiplying the Par Value to the Coupon Rate. Using our example, the Coupon Payment would be £500 (£10,000 times 5%). This means that the bond will give us £500 every year for 20 years.

The Cash Flow

Institutions that are willing to go into debt to finance their goals start, like anything else, by going to the banks. The bank will be reviewing the institution’s overall business and financial health. When banks deem the institution worthy of the debt, they then act as the facilitator of the loan.

Banks will be the ones making the bond document, and they will look for investors who are willing to buy these bonds. The money given by the investors who bought the bond will be the amount of money given to the institution that applied for debt financing from the banks.

What is in it for banks as a facilitator, you asked? Well, they get a fee from this transaction. It is like a professional’s fee for being an intermediary between both parties.

The illustration above shows and explains how bonds are made and how the cash flows from the three major players, which are the company, banks, and investors.

This is the most straightforward and simplest form of how bonds work.

In addition, with government entities, the method they undertake to acquire debt is the same as with companies: by going to the banks.

There are two ways in which we get money from bonds. It is by acquiring the coupon payments and holding the bond until its maturity date. Or, sell it into the secondary bond market, which is just like the stock market, but for bonds, this is where the complexity of bonds comes in as central bank interest rates play a major role in it. 

Risks

Just like with any other investment, bonds have their own risks as well. The three main drivers of risks are the chance for companies and governments to fail, interest rate changes, and inflation.

• Failure of companies and governments/credit risk: I’ll start with companies. There are chances that corporations could decline or, worse, cease to operate due to poor management and unsustainable debt. This causes companies to not be able to pay their debt obligations, namely the interest payments. This also causes a ruckus on the face value of the bonds, as investors will be willing to sell their bonds at a lower price due to the company’s decline and/or bankruptcy.
  
  On the other hand, government bonds are considered risk-free assets, especially those that are issued by the US government. This is because, firstly, the US is the number one economy to date, and secondly, governments can print more money and increase the debt ceiling to be able to fulfil their debt obligations. Nevertheless, printing more money in the long run can cause runaway inflation, which can result in future problems in the economy like recessions if not controlled.

• Interest rate sensitivity – Interest rates are controlled by the central banks. These banks are responsible for regulating the flow of money in the economy and, as much as possible, reducing the risk of an economic crisis. Moving forward, interest rates are reversely proportional to bonds; when the interest rates go up, the bond’s market value goes down, and vice versa. We have to take note that what is being greatly affected here is the par value, or the initial price of the bond, not the ability of companies and governments to pay the interest payments to their bond holders.
  
  Let’s say we bought a government bond at an interest rate of 3% at the time of issue. Then, two years later, the central bank decreased the rates to 2% because of various economic factors. This then caused the current government bond interest rate to also go down to 2%.
  
  We, who bought the bonds at a 3% coupon rate, have a greater advantage, as other investors will be willing to buy our bond at a higher face value than what we initially paid for it. Why is that? well, because the current coupon rate on government bonds is now 2%, which is less than how much we bought them a few years ago. See an example below.

I am sure everyone will prefer the left sample to the right. That is why investors will want to buy the bond with a higher coupon rate. This causes the bond holder, who has a higher coupon rate, to sell it at a higher price than what they initially bought it for. Like in the example above, the £10,000 bond par value can be sold for more than that price because there will be demand for that higher coupon rate. That is just the context, not the real computation of how much that bond should be sold, because we have to consider the term and coupon rate of how long it has been since the bond was held by the investor who plans to sell it.

On the flip side, if the central bank increases the rate, so will the current bond rates that will be sold to investors; this will in turn make the previous lower coupon rate bonds have a lower par value selling price in the secondary bond market.

At the time of this writing, the current central bank rates in both the US and UK are between 0% and 0.25%. The UK 10-year bond coupon rate is at 0.246%, while the US 10-year bond coupon rate is at 1.093%. The current levels are at historical lows, so when the central banks increase the rates again and you have a current holding of bonds, let’s say the 10-year bond, you will certainly be in a pickle because your bond face value will be devalued in price.

Nonetheless, if unprecedented decisions are made by the central banks by going into negative interest rates, then surely your bond par value will appreciate in price.

In conjunction, I know that the relationship between central bank interest rates and bonds sounds complex, but there is another way to stay away from this, and that is by not buying and selling bonds, or, in short, not trading the bonds you bought.

Once we purchase a bond directly from the banks that issued it, we are considered first-hand bond holders, or we can also purchase it from the bond market as secondary holders instead. What is essential here is for us to just hold the bonds up until their maturity date and not mind the price fluctuations and interest rates of the market. We will still be receiving the coupon payments and the par value once the bond matures, as long as we make sure that our bond came from a stable company and government. That is the easiest and least stressful way to invest and handle bonds.

• Inflation – in order to equalise or supersede the inflation rate, even by a narrow margin, by utilising bonds, we must make sure that the coupon rates of our bonds are always equal to or above inflation. The average inflation rate is around 3%, so finding a bond coupon rate that equals or more than the said percentage will suffice.
  
  Nevertheless, higher coupon rates are only applicable for bonds with long-term maturities of 10 to 30 years, which can be considered a higher risk in terms of inflation because no one knows what will happen to our economies during that very long time period. Inflation could go very high, even at levels during the 1970s, when inflation reached 12%. That is why bonds are not usually for long-term buy-and-hold investment horizons.

To Sum It Up

• Bonds are debt instruments where corporations and government institutions borrow money from people or groups of people.
• Bonds consist of three important characteristics: Face Value, Coupon Rate, and Term.
• Banks are intermediaries for investors looking for yields and governments and corporations that want capital via debt financing.
• Failure of the government and corporations, credit risk, interest sensitivity risk, and inflation can substantially impede an investor’s bond investment returns.

Bonds, even if some investors do not like them, are still an important asset class. It is straightforward and easy to understand. Plus, knowing and understanding bonds can give us an edge in stock investing too; it is as simple as knowing which one has better yields and returns depending on the current market conditions and situations. Bonds will always have a place in our portfolios, depending on our financial goals and objectives. Remember, the application of knowledge is power itself; our hard work will not be fruitful without it.

Knowledge is my Sword and Patience is my Shield,

Evan Louise Madriñan / elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.