Loan Governments and Companies money with Bonds

Learn various and clear definitions about bonds and how they work so you can invest properly.

I just loaned the South African government R500 while sitting in a coffee shop. The government will pay back the loan in 5 years and pay an annual interest of 9%, I can recall the loan whenever I want to and have it paid back in full. There is risk involved yet this is one of the least riskiest investments I can make. The great part is that I did all of this from my laptop while drinking a cappuccino (The Power of Technology and the Internet). In moments I can purchase government and corporate bonds and become a lender to large institutions and countries . In todays article I am going to be discussing What are Bonds and cover various bond definitions plus how to buy different types of bonds.. lets go..
 

What are Bonds

A bond is an investment security that enables investors to lend money to a company or a government for a pre defined period of time. Investors then receive regular interest payments in exchange for the money that they lent to the government or company. When the bond reaches maturity the bond issuer(the borrower) returns all the money that the investor borrowed them.

There are different types of bonds, differentiated by the source of the bond, the length of the bond and the type of interest it pays and when it pays that interest. The bonds serve different purposes for both borrowers and lenders. Lets break this down a bit more...

Source of Bond:

Government Bonds are bonds issued by national government, usually by the treasury/finance department of a country. There are standard bonds that governments issue such 2year, 5year and 10year bonds. Financing from these bonds is generally used for a diverse set of things that have to do with running the country, development etc. However governments can issue bonds for specific purposes and give those bonds names according to their purpose.

Municipal/Local Bonds are bonds issued by local governments such as municipalities ,provincial/state government and cities. The money raised from these bonds finances the needs of the particular city, town, municipality or province. They may also be categorized by the duration or specific purpose.

Corporate Bonds are bonds issued by companies, mainly large corporations. The finance from these bonds is used for general or specific purposes for the benefit of the company.
 

Length of Bond

Bonds have a specific lifespan that they exist for. Once they mature the borrower has to return all the capital they borrowed from investors. Popular periods are 2 year, 3 year, 5 year, 8 year, 10 year and 30 year bonds. Longer term bonds tend to pay the most as they carry more risk , imagine you borrow an entity money for 30 years but after 30 years they no longer exist yikes! Generally governments will issue long term bonds as there is a high chance that a country may exist after a longer period, though it politics and leaders may change which can affect bonds (what if the new leaders do not want to pay anymore?).
 

Interest Payments

Interest payments can mainly be categorized in to two types. Bonds that have Fixed Interest Payments based on the Par Value(the initial amount the bond is worth) and Bonds that are Inflation Linked. Investors will choose between the two types for various reasons. Generally investors will choose based on their perception of the countries currency and expected inflation levels. Buying a bond with a fixed interest rate may carry the risk of having the income value eroded by inflation. This happens when real inflation is higher than the percentage of return. Inflation linked bonds may carry the risk of decreasing percentage return that is below the fixed return if inflation decreases or does not increase. The two types are however for different purposes to different types of investors and both may be used in a risk adjusted portfolio.

How do bonds work

Before we go any further, let us understand some basic bond terminology. This will help us read reports, articles, offering documents, analysts statements etc. a lot better.

Issue Date: This is the date the bond is first issued. Basically the day the issuing institution takes the loan from lenders. The issue date is often not spoken about however it is extremely important to know as it may help you judge the credit worthiness of the borrower a lot better. An example of this would be to ask yourself what was going on at that time in the company/country when they needed the loan. Was it to expand?(Growth) or Was the loan to cover expenses? Was the loan to prop up the financial books?. Determining the real reason why a bond was issued and not just what is said by the borrower will give you more insight and help you assess the risk better and if the risk is worth the reward.

Face Value/Par Value: The face value which is generally referred to Par Value when referring to bonds is the initial value of the bond when its issued. It is also the amount that is expected to be paid to the bond holder when the bond matures. The two terms Face Value & Par Value are used interchangeably.

Issue Size: This is the total value the institution is borrowing. It is the number of bonds issued multiplied by the face value. Lets say 100 000 bonds are issued, each with a value of R1000. The calculation we get becomes 100 000 x 1000 = R100 000 000 (One Hundred Million Rands). This means that the institution is borrowing R100 Million from lenders. Knowing this can help you assess the credit worthiness of the borrower. Most importantly you will know if the risk is worth the reward.

Maturity Date: This is the day the borrower pays back the principal(face value) of the bond. If the bond was issued with a price of R1000 and then the bond holder should expect to be paid R1000 on the maturity date regardless of the price of the bond in the open market (except if the borrower defaults). The distance between the Issue Date and the Maturity Date equals the length of the bond.

Coupon Rate: the coupon rate is the periodic payment that is made by the borrower, it is based on the face value of the bond. If the coupon rate of our R1000 example is 10% per year, then the borrower will pay R100 each year to the bond holder until maturity when they return the R1000. Investors who plan on holding the bond to maturity generally care about the coupon rate as that is what determines how much they make provided they bought the bond at the face value price. The coupon rate is called the Coupon because there was a time when investors got an actual bond certificate with coupons to tear off and present to receive payments. Due to the advent of technology this has changed but the term has stayed.

Yield: the yield of the bond is how much interest the bond pays in relation to its current market value. Just like stocks bonds are traded in the open market so they value changes based on supply and demand. The nominal value of the coupon rate stays the same however as the bond increases or decreases in value the interest rate can be said to change. Using our R1000 example this can be illustrated like this: The investor buys a bond worth R1000 that pays a coupon rate of 10% which is R100, after 5 months the bonds market value decreases to R800 yet the bond still pays out R100. A new investor buys the bond, that new investor can be said to be earning a rate of 12.5 % (R100 out of R800). This is because he only invested R800. But lets say the value of the bond had increased from R1000 to R1200 but still paying R100. Then the new investor would be earning a rate of 8.3% because they invested a higher amount. This is the yield changing.

how are bonds issued

Bonds are generally issued in two ways. These are:
 

Bond Auction.

A Bond Auction is what it sounds like. The institution holds an auction to sell it bonds and the money it gathers is what makes up the loan. Most auctions are attended by other large institutions who then sell of the bonds to other investors. The auction format is popular with government entities.

Underwriting Syndicates

The second way that bonds get issued is that the borrowing entity approaches a finance institution to underwrite their bond. A syndicate of firms will generally be formed who will collectively underwrite the bond. This means that they are collectively loaning the borrower capital. The syndicate will then sell the bonds to other investors. In effect the syndicate takes the risk of not being able to sell the bond and get stuck as the lender, meaning if the borrower cannot pay back they have taken the risk of default themselves. This method of issuance is generally used by corporations.

Regardless of how the bonds are issued some eventually end up in the open market. This allows other market participants to buy and sell them. Since the market is free, buyers and sellers can set any price. These lead to bond prices deviating from their face value and fluctuating just like stock prices.
 

how are bonds traded

Bonds can be traded just like stocks and listed on an exchange. This then forms the bond market. Most countries have a local bond market where bonds are traded. The basics of supply and demand affect bonds just like other asset groups. These are driven by a diverse set of reasons that investors have. The thing to keep in mind is that bonds are essentially just loans that can be bought and sold. The current bond holder is always the lender. So when you buy a bond you assume all the risk that comes with lending out your money. At the same time you assume all the benefits as well.
 

So How do you make money from bonds

You can make money in two ways from bonds.
 

1. Trading Bonds.

Since the prices of bonds fluctuates you can capitalize on the change in prices. You can trade bonds like you do stocks. Buy a bond at a lower price and sell it at a higher price. In order to successfully do this you will have to understand the bond market and what drives the prices of bonds. Just like stocks, bonds have fundamental and technical factors that result in price movements. So before you decide to trade bonds educate yourself on them. Learn to evaluate and assess them. Furthermore understand what role you want them to play in your portfolio. Bonds do not always complement portfolios the same way. Every investor must buy assets according to their investment objectives, understand yours.

One thing to note about trading bonds is that the bond will generally always pay out its face value at the maturity date. So remember that the value of the bond at maturity does not matter. So if you buy a bond with a face value of R1000 but it trades for R1200, at maturity you will be paid R1000. This is something to be aware of if you are going to be trading bonds and attempting to make money from the changes in prices.
 

2. Interest Payments

Receiving those sweet interest payments is always a lovely experience. Knowing your money is working for you just feels good no matter which way you look at it. So the second way to make money from bonds is earning interest. This is the easier way then trading bonds. Basically you buy the bond to hold it to maturity and along the way you earn some interest. Generally bonds will pay higher interest than banks because they are more risky and because the borrowers want to attract lenders and be a better option than parking your money at the bank.
 

Just remember that interest payments are based on the face value. So a bond that cost R1200 but with a face value of R1000 and interest(coupon) of 10% will pay R100. If you buy this bond for R1200 you have technically over paid because the interest will be 8% to you. Worse if you hold to maturity you will lose R200 on your investment when the bond returns the face value of R1000. So keep this in mind and use bonds wisely.
 

What are the basic risks

Bonds are often presented as low risk investments, especially those issued by governments. However this is not true. Bonds do have risks just like all investments do. These are the following risks among many that you should be aware of:

1. Borrower Default

The biggest fear of any lender. The borrower defaulting means you may not get your money back or all of it. Defaults happen when a borrower fails to pay back the principle on the maturity date. This happens to both countries and corporates. Assessing the credit score (yes, countries and corporates have credits scores) called Credit Ratings is important. However do not just rely on the Rating Agencies for these, take a look at the books yourself and make your own assessment. This how you may be able to find underpriced bonds that pay well or be able to avoid overpriced bonds that pay little. However at all cost avoid bonds that borrowers where it is clear they will fail to pay back no matter how sweet the interest rate is.
 

2. Liquidity

A market is called liquid when there is generally a high probability that you will be able to liquidate an asset at a fast speed. This happens because there is high amounts of liquidity(capital) in that market. This capital is made up of both buyers and sellers. The stock market is considered liquid because it is generally not difficult to sell stocks. However not all stocks are equally liquid, some are not at all. Since bonds trade on a market, they too can be liquid or illiquid. This means you can find it difficult to sell a bond at will. Thus it is important to assess a bonds liquidity levels prior to investing in it. Nothing is worse than not being able to sell an asset when you want to in the open market.
 

3. Inflation.

The silent killer that is always ready to destroy value. Inflation is the increase in prices of goods that is caused by an increase in the money supply. Central Banks and Governments can enact policies directly or indirectly that increase inflation. When inflation increases the purchasing power of the currency weakens. This is very dangerous for bond holders as they may be technically earning an interest and will receive the principle back but they may find their money has decreased in purchasing value so much that investing in bonds seems pointless. Bonds are not immune to inflation unless they are inflation linked or have some other way to beat inflation.

These are just some of the main risks to look out for. There are plenty more. The important thing is to monitor them.

How much money do you need

Before discussing how to buy bonds lets discuss how much money do you need.

You honestly do not need much anymore. There was a time where the costs of buying a bond from an exchange had costs. These days it is fairly easy and affordable. I recommend having a R1000 but you can even have R10 and buy a bond ETF. That is how I bought my first bond. It was via an ETF. Since then I have a staple of global corporate and government bonds in my portfolio. I am a risk taker so there are a few junk bonds in my books.

Where do you buy bonds?

There are plenty of options when it comes to purchasing bonds. The options suit all styles of investing and all budgets. Here is a basic list of places to get you started:

1. RSA Retail Government Bonds

This is an option for the conservative investors who still want to make decent returns yet feel secure. The bonds listed here are directly from the treasury and are a great vehicle for parking money and earning interest. You can only South African bonds on this website as it is a government platform. You can register and transact online. The alternative to this website is the Post Office where you can buy the same bonds.

Budget: R100 (minimum)

Type of Bonds: RSA Government Bonds for Retail Investors

Yields: Good

Location: Local

2. Brokerage Account

This option depends on who is your broker. Some brokers offer bonds and others do not. If you are in South Africa you will have to have an account with the big stock brokers to access bonds. Alternatively you can use ETFs to gain exposure. If you want to directly buy bonds the broker I recommend is Interactive Brokers. They have fees but are the best at getting you a seat at the table. The next best option is Easy Equities and just using ETFs.

Budget: R10 to R5000(minimum)

Type of Bonds: All types

Yields: Great

Location: Global and local

3. Exchange Traded Funds

This is by far the easiest and most flexible option provided you use an affordable broker. ETFs can offer you an array of bonds to be exposed to. The disadvantage is that most ETFs do not directly distribute the interest earned back to investors but rather re-invest it.

Budget: R10 (on Easy Equities)

Type of Bonds: All types

Yields: Good

Location: Global and local

Final thoughts

Bonds are a great tool for diversification and serve as a great income tool in a well diversified portfolio. Now that we know a little more about them, we can now explore the topic of how to use bonds to make money in part 2.

Happy Investing

-Omega.

Remember: Opinions expressed in this article do not and never will constitute financial advice. Every persons financial situation is different, I recommend you speak to a financial adviser about your

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