What are Bonds?
Key Concepts
-Bonds, often known as fixed-income loans, are a sort of loan. A bond issuer draws money from a lender for a certain length of time with a fixed repayment schedule.
a) The amount borrowed = Principle
b) Interest paid = Coupon
c) Each bond provides its principal, maturity, and coupon rate (interest rate).
- This additional interest is also called the yield of the bond(coupon rate), and yields have an inverse relationship with credit rating and are heavily impacted by interest rates set by the government
- Default Risk: the risk that a lender takes on in the chance that a borrower will be unable to make the required payments on their debt obligation
Other Names for Bonds (Jargon)
Fixed Income - because these assets provide a form of payment through fixed periodic payments
Debt Securities - because when an investor buys a corporate bond it is essentially them loaning money to a company with the expected return of interest payments and the initial principal.
How do Bonds and Loans differ?
- An important aspect of bondholders is that they have priority over shareholders. As a result, before paying dividends to shareholders, issuers pay coupons to bondholders.
- Bonds and loans are both types of debt, with loans coming from a single lender and bonds from multiple bondholders.
- Loans are private, with little disclosure, while bonds are public, with more information about terms and covenants.
- Bonds are comparable to mortgages and auto loans in that the lender knows the number of payments, the amount within each payment, and when they will occur.
Why invest in Bonds?
1. Bonds provide safety as they enable investors to time their investments, given that bonds have maturity dates.
2. Additionally, bonds tend to move in the opposite direction of stocks, offering investors diversification.
3. During periods of economic expansion, bond prices usually fall while stock prices rise, reflecting the competition for capital among investors.
What Kinds of Risks are Associated with Bonds?
1. Default Risk - Failure to pay coupons or par value
ex) Eurozone Crisis
2. Interest Rate Risk(Price) - Interest Rate↑Bonds Value↓
3. Inflation Risk - Overtime Purchase Power of Coupon/Par Value↓
*See why in “Interest Rates and Bond Prices”
4. Liquidity Risk - difficult to sell bonds/ Sell at Lower
a) Liquidity: measures the ability to sell an asset
B) Bonds Liquidity < Equities
5. Reinvestment Risk - If an investor is reinvesting coupons as they are received, they run the risk of reinvestment. This is because if the bond's coupon yields are reinvested, new additional interest rates may vary, and the investor may end up investing in new bonds with lower coupon rates.
Additional Risk - Ex) Coupon in foreign currency
Interest Rates and Bond Prices
- They have an inverse relationship
a) As the interest rates increase, the face value of the bond decreases, and vice versa
For example, let’s say I bought a $1000 bond with an annual coupon at 5%. If the interest rates become 10% the next day, my bond is worth less than a $1000 bond with the better 10% annual coupon.
What Are the Tax Liabilities of Bond Investments?
1. The tax liabilities associated with bond investments can vary based on factors such as the type of bond, holding period, and the investor's tax jurisdiction. Here are some general considerations:
Example: Suppose you purchase a bond at a discount of $900 due to rising interest rates and sell it for $950 after two years. This transaction is considered a capital gain (sold above the purchase price), and taxes are due on the $50 difference. If the capital gains tax rate is 20%, you would owe $10 (20% of the $50 gain). In the United States, capital gains taxes are lower than taxes on ordinary income. Alternatively, if you sell the bond for $860, resulting in a capital loss (sold below the purchase price), the $40 loss would reduce taxable income in the sale year, lowering your tax bill by $8 (20% of the $40 loss).
2. Coupon earnings from bonds are marginally taxed. However, municipal bonds do not incur taxes on coupon payments, but they generally come with a lower coupon rate.
What Credit Ratings Mean for Bonds
a) As yield goes up, a bond’s credit rating normally goes down, and vice versa.
b) Credit Rating Agencies like Moody’s Corporation rate a bond based on its creditworthiness.
*Credit rating is as important as a bond’s yield because a bond with a lower credit rating usually indicates that the bond has a higher default risk, which is when the issuer fails to return the principal with the interest back to the holder within the maturity date.
c) Investment grade bonds are bonds above a BBB rating, and junk bonds are below a BBB rating. When investing in bonds it is important to find a healthy balance so you are getting a good interest rate but also don't fear a risk of being defaulted.
High Yields vs High Credit Ratings
- It is of crucial importance to choose bonds that have a healthy balance between crediting rating and yield.
Let’s compare examples)
1. Argentina’s 10-year Treasury Bill(Bond) has approximately a 49.680% yield. Their credit rating is sitting at CCC and has reached a D. To compensate for their extremely low credit rating, they have to offer extremely attractive yields to attract and hopefully issue some bond contracts.
2. U.S. 10-year Treasury Bills have a yield of 3.82%, and a credit rating of AAA. This indicates that all interest payments and principal will be returned on time.
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