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22 May 2011

WHATS in a bond? A debt instrument by any other name would surely smell as sweet; Shakespeare might have uttered these words had he been a bond trader.

Fortunately for everyone, he was possessed of loftier aspirations, and whats more bonds emit no odour whatsoever, though they do come in different shapes and sizes.

So, what is a bond? cashy gives you the low-down.

What is a bond?

A bond is not nearly as fancy as it might initially seem, it being essentially a loan that investors make to the bond issuer where the payback date and rate of interest are explicitly stated in a legal document.

The price of a bond when it is first issued is basically the amount of money being loaned, and is referred to as the bonds face value or principle. The investor is compensated for this loan by receiving an annual payment known as a coupon, which is an interest payment expressed as a percentage of the principle.

How long does this happen for?

Bonds are issued for a specified period of time, usually between one and 30 years.

For instance, XYZ Company is raising capital by selling bonds with a face value of $1,000, a coupon of 6% and a maturity of ten years. This means that anyone purchasing this bond would receive $60 a year over the next decade. After ten years, the bond will have reached maturity and they will receive their principle back and would have also made $600 in interest payments during the term a total of $1,600.

Why issue bonds?

Governments, municipalities (states, towns, localities) and corporate institutions are frequently looking to raise capital in order to finance their projects and activities. There are essentially two methods of financing available to facilitate this, either through equity or debt.

Raising capital through equity entails offering a share of ownership in exchange for an agreed consideration. For instance, lets say you and a friend decide to go halves on a pizza; this represents an equity share agreement with each participant taking a 50% stake in the asset (the pizza).

If the same transaction were to take place using debt to raise funds, you would instead borrow the money and agree to pay it back at a later date, usually at an agreed rate of interest. This represents a debt transaction, and is currently the most common model by which economies function.

This is why the US, despite boasting the largest economy in the world, is many trillions of dollars in debt as it is required to borrow heavily in order to finance its expenditure. It doesnt, however, borrow by taking out a loan as you or me might do; it does so by selling treasury bonds.

In this way, sovereign nations sitting on surplus cash become creditors to debtor nations. China currently enjoys some renown as the largest holder of US treasuries, owning many hundreds of billions of dollars of US debt.

Treasuries are just one example of the multitude of bonds available. A brief mention of the others would include municipal bonds, corporate bonds, bearer bonds, zero-coupon bonds, perpetual bonds. the list goes on and on.

What are the risks?

Of course there is always the chance that inflation might rise above 6% over the course of the decade and erode the value of the principle (inflation risk), or that XYZ company could go bust (default risk). Despite this, bonds are still considered a pretty safe bet.

With regards to risk, bonds are actually rated according to their likelihood of default, with the safest receiving an AAA rating from one of the ratings agencies, such as Standard & Poors or Moodys.

Those possessed of a more cavalier attitude are also catered for with the riskiest bonds, known as junk bonds, offering the highest returns to reflect their high chance of default.

Are they liquid?

The short answer is yes. You dont need to hold your investment until maturity, as theres a lucrative secondary market where bonds are traded among institutions, as evidenced by the armies of bond traders in the worlds financial centres.

Are you thinking of investing in bonds, or have you already done so? Do you have other top tips to boost savings rates?