Investment in bonds

06.10.2022

 

 

 

 

- Good afternoon, Yessen, could you tell our readers a little bit about investing in bonds?

 

- Good afternoon, dear readers! Before talking about investing in bonds, I would like to tell you a little about the financial instrument itself and terminology. Bonds are debt securities that are issued by different issuers in the process of attracting borrowed funds for a certain fee (coupon) and for a fixed period. In fact, when buying a bond, you act as a lender to the bond issuer. You, as an investor, have an interest in buying a bond expecting a stable cash flow throughout the bond term. The Issuer is interested in raising funds for projects in need of financing.

 

- What do you mean when you talk about the issuer of the bond and what main bond components you would note?

 

- The issuer is the party that borrows funds. This party may be a State, a municipality, an international financial organization (MFO), a quasi-public sector enterprise or a private enterprise (corporation). The main component to pay attention to when analyzing a bond is the yield to maturity (YTM). YTM is determined by the market based on all the characteristics and risks of the bond, including credit quality, maturity, currency, coupon and repayment structure of the bond. The YTM of the bond shows the average yield of the bond in annual terms, which the investor will receive when holding the bond until maturity.

 

Thus, bonds are characterized by the following indicators, which are used to evaluate an ordinary bond:

•Nominal value - the price at which the bond will be redeemed by the issuer at the end of the term.

•Maturity date — the date of payment of the nominal value of the bond, which is indicated by the issuer during the issue. Sometimes an offer date is set when the issuer can pay the nominal value before the maturity date.

•Coupon, or coupon income, is cash interest payments to bondholders from the issuer. For example, the issuer can set a coupon of 10% to the nominal value of a 1000 tenge bond with payments twice a year. This means that during the year the investor will receive coupon payments the amount of 100 tenge in two equal payments.

•Market price — the price for which you can buy this bond on the market. It can be higher or lower than the nominal value. The market price depends on various factors: interest rates, the level of supply and demand. Most often, the range of fluctuations in the market price is 95-105% relative to the nominal value.

•Based on all these factors, as I noted earlier, the yield to maturity is calculated.

 

- Yessen, you said that YTM is the main indicator that you should pay attention to when analyzing bonds, what factors influence YTM?

 

- Actually, this is a good question. The main factor affecting YTM is the credit quality of the bond’s issuer. In addition to the breakdown of bonds by type of issuers, bonds can also be broken down by the level of credit quality. Bonds of states, municipalities, MFOs and quasi-public sector enterprises have a higher credit quality due to repayment guarantees from the states, while the credit quality of corporate bonds is lower due to a higher probability of issuer default. Well–known international rating agencies - S&P, Moody's, Fitch, evaluate the credit quality of individual issuers and bonds by assigning credit ratings on an evaluation scale from "AAA" to "D". According to this scale, the "AAA" rating means the highest credit quality and no risk of default (risk-free status), and the "D" rating means that the issuer is at the stage of default and it is not plausible to expect repayment on its bonds. Bonds with a credit rating above BBB- (inclusive) are included in the category of investment quality or investment grade (IG), bonds with a credit rating below BBB- are called high yield (HY). Taking into account the possibility of a company with a higher credit quality to attract financing at a lower rate, YTM bonds with investment quality are significantly lower than YTM of high yield bonds.

 

- What else can bonds differ from each other (besides the type of issuer and credit quality)?

 

- Bonds can also be classified by coupon type. Thus, bonds whose coupons are non-permanent or tied to a certain financial indicator are called floating rate bonds or forward rate note (FRN).

 

An example of a linked financial indicator may be the refinancing rate or LIBOR. Accordingly, a change in the base rate leads to a change in the coupon rate. Another example of a financial indicator is the consumer price index (CPI), which is linked to the coupon rate of an inflation linked bond or the yield of treasury bonds that provide protection against inflation – Treasury Inflation-Protected Securities (TIPS).

 

Secured and unsecured bonds are also distinguished. They are also called covered/collateralized and not collateralized, respectively. For covered or secured bonds, payments in case of default are guaranteed by any assets of the issuer: real estate, property, securities. By offering collateral for a bond, the issuer seeks to increase its attractiveness and, as a result, reduce the cost of financing (YTM). In the case of unsecured bonds, payments depend only on the issuer's solvency.

 

According to the type of repayment, there are early redeemable, revocable (callable), amortised and irrevocable bonds.

 

The bonds can be convertible: in this case, the investor is granted the right to exchange them for the issuer's common shares. The conversion option reduces the yield of the convertible bond, therefore, the convertible bond has a lower YTM relative to a similar non-convertible bond.

 

Bonds issued abroad are divided into foreign (issued on the market of one country in the currency of that country) and Eurobonds that are placed on the markets of several European countries. Long-term US Treasury bonds are considered less risky (volatile) in the world. It is also worth noting that the shorter the duration (term) of the bond, the lower the volatility.

 

- It turns out that bonds are a safer tool for a retail investor?

 

- In terms of safety, I would agree with you. Bonds demonstrate low price volatility and generate a steady income. However, the valuation of the bonds themselves, in my opinion, is a more difficult task than the valuation of stocks.

 

- Yessen, what is the difference between investing in bonds and the stock market?

 

- The process of investing in bonds for a retail investor is different from the investment process for an institutional one. This is due to the need to interact with investment banks and a large nominal value of bond issues.

 

Stocks, for example, are traded primarily through securities exchanges such as the New York Stock Exchange, the London Stock Exchange or others.

 

The situation is different with bonds. While some bonds are traded on a public exchange, the vast majority of them are traded on an over-the-counter (OTC) market between large investment banks acting on behalf of their clients.

 

One of the problems of the OTC market is that it does not provide the same price transparency as the public market. Therefore, investing in bonds requires a deep level of knowledge in their valuation and constant contact with investment banks. At the same time, it is worth noting that the liquidity of low-risk bonds (for example, US Treasury bonds) is significantly higher than the liquidity of individual stocks, while the liquidity of the bond decreases as credit risk increases. Thus, the liquidity of speculative bonds is much lower than that of investment-grade bonds.

 

Note that the bond market is constantly developing and now there are several specialized bond brokers, and most online brokers and discount brokers already offer access to bond markets. Treasury bonds and TIPS, for example, are usually sold directly through the federal government and can be purchased through its TreasuryDirect website. A retail investor can also get indirect bond exposure through fixed income ETFs or mutual funds that invest in a bond portfolio, this method will help build a diversified portfolio and does not require a large amount of investment capital.

 

- Yessen, thank you for such an interesting and detailed interview. We hope that this information will be useful to our readers.

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