Thursday 20 May 2010 by FIIG Research Legacy

What is a Bond?

What are bonds?

A bond is a security that pays a defined distribution (the coupon) for a given period of time (the term) and repays the face value of the security at maturity. It is a loan from an investor to the issuer of the security. Over the counter (OTC) bonds are tradable through the secondary bond market. If the bonds are listed they can be bought and sold on the Australian Stock Exchange (ASX).

What are the benefits of investing in bonds?

Bonds offer investors:

  • Capital stability: Bondholders have priority over hybrid and equity holders in the event of liquidation. Assuming the issuer of a bond remains solvent, they are contractually obliged to pay back the principal value to the bondholder.
  • Regular income: Fixed income securities provide a regular income stream through coupon (interest) payments, giving holders the ability to tailor their portfolio maturities.
  • Diversification: Holders of fixed income securities enjoy diversification from the two most highly cyclical asset classes - equities and property.
  • Higher returns than deposits: Many investors use term deposits which deliver minimal risk but generally earn relatively low returns. By moving slightly down the bank issuer‟s capital structure into bonds (senior or subordinated) investors can retain their exposure to the issuer but earn a higher return (Page 2 - Capital Structure diagram).
  • Liability management: Typically, bond maturities vary from one to ten years and can be traded before maturity to meet liabilities.
  • Liquidity: Low risk, highly liquid fixed income investments like government bonds can be sold at short notice if needed.
  • Downturn protection: Generally, a fixed income allocation will act to protect your portfolio during a cyclical downturn. A larger allocation will provide greater protection.

Common terms:

Issuer is the entity (or borrower) that issues the bond to raise money from investors. Issuers in the Australian bond market include the Commonwealth Government, state governments and territories, large institutions and corporations.

Maturity is the date when the bond is due for repayment by the issuer. The principal plus any outstanding interest of a particular security will be repaid on this date.

Face value is the initial capital value of the bond and the amount repaid to the bondholder on its maturity, usually $100.

Coupon is the rate of interest paid on a bond. Coupons can be paid annually, semi-annually or quarterly or as agreed in the terms of the bond. The coupon rate can be fixed or floating for the term of the bond. If it is a floating rate then it is likely that it will be linked to a benchmark such as the 90 day bank bill rate.

Call Option is an option that gives the holder the right but not the obligation to buy a bond at an agreed upon price (the "strike price") at any time up to an agreed upon date.

What are the risks to investors?

There are two key risks when investing in bonds:

  • Credit risk: The risk that an issuer may be unable to meet the interest or capital repayments on the bond when they fall due. Generally, the higher the credit risk of the issuer, the higher the interest rate that investors will expect in order to risk lending funds to the issuer.
    Bonds normally represent senior or subordinated debt in a liquidation scenario. The order in which repayment to investors is made after liquidation of the issuer is demonstrated by the (corporate) capital structure diagram below.
  • Interest rate risk: The risk associated with an interest bearing asset, such as a bond, due to variability of interest rates. In general, as rates fall, the price of a fixed rate bond will rise, and vice versa. This creates the likelihood of a capital gain or loss in the event the holder needs to sell the bond prior to maturity. Similarly with floating rate notes, if market sentiment towards the issuer changes, the premium paid by the issuer over the benchmark known as the “spread” will move away from the issuing premium.