Bond – what is it?
A bond is a security issued in a series, in which one of the parties (the issuer of bonds) states that he is a debtor towards the other party, referred to as a bond holder, which involves the obligation to meet a specific service. It may be monetary or non-monetary. Usually, these are interest on the incurred debt.
The bonds are classified in the category of debt financial instruments. In comparison with shares, the bond holder does not gain any rights towards the issuer, such as dividends, joint ownership or the possibility of participating in general meetings.
Kinds of bonds
There are many different types of bonds available on the market. Taking into account the type of issuer, we can distinguish the following types of bonds:
1. Treasury bond (government) – this type of bonds is issued by the State Treasury, so you can often meet with other terms, such as “state bond”. In the case of Polish Treasury bonds, we can distinguish the following options:
- retail bond – it is a debenture paper characterized by a small nominal value. Its recipients are primarily individual investors. These are usually bearer securities;
- wholesale bond – addressed to both natural and legal persons as well as organizational units without legal personality. They are offered on the primary market in the form of tenders. The tenders are organized by the issue agent, which is the National Bank of Poland, and the bonds usually have a large face value;
2. Municipal bond – it’s a municipal debt. Its issuers are territorial self-governments;
3. Bonds of legal entities – this is, for example, corporate bond issued by the company. Its buyer has the right to interest and the right to return capital at its maturity.
Taking into account the place of issue, you can list:
- Domestic bonds – issued in the issuer’s country. They are expressed in the national currency and their recipients are primarily domestic purchasers;
- foreign bonds – they are issued outside the issuing country. They are nominated in a foreign currency and their recipients are foreign buyers;
- Eurobonds – these bonds are sold on the international market. They can be issued in any currency.
Bonds can also be divided due to the bondholder designation. Then the following options are available:
- personal bond – indicates a specific owner of a financial instrument. The right of ownership may be transferred on the basis of assignment principles along with the issuance of a bond document, where such bonds may contain restrictions on their transferability, and in some cases their sale is prohibited;
- bearer bond – in this case the transfer of ownership takes place by presenting the buyer with the bond document by the entity that disposes of the debt paper. The majority of bonds are bearer financial instruments.
The next classification of bonds includes the maturity period, i.e. the number of years in which the issuer is required to fulfill the obligations imposed by the bond. The redemption date therefore means in practice the date of cessation of the debt, as the issuer will redeem the security within this period. Taking into account the maturity date of the bonds, we can distinguish the following types:
- short – term bonds – their buy-back period reaches one year
- medium – term bonds – bonds with a maturity of 1-5 years
- long-term bonds – debt securities with maturity over 5 years.
At this point, it is worth mentioning one more type of debt securities, which are perpetual bonds, which are also referred to as consoles. The perpetual bond has it that it is never bought out. Its owner receives a so-called perpetual pension, i.e. an infinite stream of interest.
Another special case is the amortized bond, which does not have one specific maturity date. Usually, the issue of such bonds provides for the repayment of their nominal value in installments whose amounts and dates are set in accordance with the terms of issue.
Taking into account the nominal value, we have the following options:
- zero coupon bonds – it is usually issued at a discount, i.e. below the nominal price. Its characteristic feature is that no periodic coupon payments are made. These are bonds from which no interest is paid;
- coupon bond – in this case we are dealing with a periodic coupon payment. Its amount depends on the issuer’s rating.
Taking into account the interest rate on bonds, we can deal with the following types:
- fixed-rate bond – in this case, the issuer undertakes to pay regular interest payments, i.e. coupons, which are calculated taking into account the fixed interest rate.
What does this mean in practice? So much so that the bondholder receives the same amount of interest in each interest period, as the interest rate on the bonds does not change. As a result, the investor achieves a fixed-rate profit, even if interest rates fall;
- floating rate bond – in this case, the issuer is obliged to pay regular interest payments, which have a variable amount. It is calculated on the basis of a variable reference rate, for example based on the WIBOR rate or the profitability of Treasury bills.
The interest paid may have a different value depending on the interest period. We are also dealing here with an interest margin, which is a kind of bonus for the buyer of debt securities. It is added to the reference rate.
The purchase of this type of bonds brings with it a tangible benefit for the investor . Namely, it protects it against adverse changes in interest rates;
- indexed bond – this is a special type of variable rate bonds. In her case, there is an additional change in interest by a specific rate, which results from changes in a specific indicator. Most often it is the inflation index. Bonds indexed in this way allow you to secure the invested funds against a drop in the purchasing value;
- zero – coupon bond – in this context, it is a bond that the issuer sells at a discount, and its redemption takes place at face value.
On the other hand, the classification of bonds due to the value of sales is based on how the price of the bonds may develop before the day of its redemption. Then we have three options:
- the bond is sold at the nominal price – then the value of the rate of return on maturity is equal to the coupon rate;
- discount bond – it’s a discounted bond. In its case, the value of the rate of return on the day of its redemption differs from the coupon rate – it is greater than the coupon rate. This category of debt securities includes zero-coupon bonds;
- bond with a premium – then we are talking about a lower value of the rate of return on maturity compared to the coupon rate.
Bearing in mind additional options, we can distinguish such financial instruments as, among others:
- convertible bond – it is a convertible bond . It releases the issuer from the obligation to redeem the bonds, provided that it exchanges them for shares issued by itself;
- income bond – it is a bond which is redeemed from future revenues from an investment financed from funds obtained from the issue of that bond;
- callable bond – is a bond with early redemption for the issuer’s demands. It allows him to repay all or part of the obligation in advance;
- Pupilar bond – in her case redemption and payment of interest is guaranteed by the State Treasury. For this reason, the property of incapacitated persons and minors is often located in them;
- structured bond – in comparison to a standard bond, it allows you to achieve a higher profit. In practice, it is a combination of two financial instruments: a classic bond with another bond, share, investment fund or interest rate. Potentially higher profit is possible due to the combination of its value with instruments that have a higher rate of return. However, this type of bond carries additional risks due to the complexity of its structure;
- savings bond – a type of treasury bonds that are not listed on the Stock Exchange, and their recipients are only natural persons, associations, as well as social and professional organizations and foundations entered in the court register. Their acquisition is also possible by non-residents, if they are entered into another official register.
How to buy bonds?
The bonds may be issued by a number of entities, including, but not limited to, the State Treasury, enterprises, local government units, commercial banks or cooperative banks. As a rule, there are two options for purchasing bonds.
The first takes place on the public offer. It is addressed to a wide range of recipients and can be advertised through various channels, including in the press, television or the Internet. The second one takes place on the way of a private offer and is addressed to at most 149 investors. What’s more, in her case, extensive advertising activities can not be carried out.
Public turnover falls into the category of organized trading and can take place on the stock exchange or in an alternative trading system (ASO). In Poland, public trading in bonds takes place on the Catalyst market. In order to buy bonds, we therefore need an intermediary, ie a brokerage house, where we will set up an investment account enabling transactions to be made.
Private trading takes place outside the public market. Transactions between investors, however, are subject to a tax on civil law transactions.
How to invest in bonds?
Bonds are particularly recommended financial instruments if we want to diversify the investment portfolio. It is a relatively safe paper, offering a higher rate of return compared to a bank deposit. It will be suitable for beginner investors who do not have professional knowledge.
Bonds bring the best results in a long-term perspective. It is therefore worth treating them as a retirement benefit. Even a small, but systematically postponed amount will positively affect the state of our future finances.
If, however, we wonder when the best time to invest in bonds is, it is worth to look closely at inflation and GDP. If we see a decline in inflation and a slowdown in GDP, and the Monetary Policy Council will gradually reduce interest rates, investment in bonds (including bond funds) may turn out to be a viable undertaking.
What is the bond yield?
In order to get to know the bond yield, ie the rate of return on invested capital, the most important components of this instrument should be taken into account, such as:
- bond interest rate
- the maturity of the bonds or in other words the maturity date
- the frequency with which interest is paid
- bond price.
When buying bonds, you should also pay attention to any additional clauses. They may give the issuer the right to take specific actions. To calculate the bond yield, you can use one of three popular measures:
- current rate of return – this is the basic measure of bond yields. It is calculated by dividing the interest paid by the purchase price of the paper;
- simple income rate (Simple Yield, Japanese Yield) – it includes maturity and bond discount or premium, or more precisely their rates. However, it omits the variable value of money over time;
- the rate of return on maturity (YTM) – this is the measure used more often. It takes into account not only the value of money over time, but also the impact of interest payments or reinvesting them at the same interest rate, assuming that bonds will be held until maturity.
Thanks to the bond yield assessment, the investor is able to compare the profitability of this investment with the implementation of other options. It should be remembered, however, that issuers exhibit considerable flexibility when it comes to the construction of debt securities. For this reason, it is impossible to indicate one ideal measure that will indicate the profitability of all types of bonds.
Is it worth buying bonds?
This is a question that many investors are looking for answers to. The following bond features speak for investing capital in these financial instruments:
- security – it is one of the safest forms of investing capital, especially if we decide on Treasury bonds;
- simplicity – bonds do not have a complicated structure, hence investing in them requires less expert knowledge. They are also characterized by high availability;
- regular, relatively reliable profit .
Remember, however, that investing in bonds also involves risk. It is the greater, the less credible the issuer is. Entities such as the State Treasury and profitable enterprises with an established position on the market are the most trusted. However, they offer bonds with a lower interest rate than small and heavily indebted entities, which guarantee potentially higher profits, however, with a higher risk of insolvency and losses of funds invested.
Shares and bonds
Both shares and bonds are classified in the category of securities or, in other words, property rights. They have the form of a document or an entry in an IT system.
Bonds as securities, however, do not give their holder rights to the issuer, which is a basic feature that distinguishes them from shares that guarantee, inter alia, the right to dividends or joint ownership. The action is a share-based financial instrument, and the bond is debt.