Investment choices - Bonds (I)
April 23, 2007All of the investment choices covered so far concern equity securities where the investor, after buying shares in one form or the other, owns part of a company. Debt securities constitute an alternative way for corporations (or governments!) of raising finance - without having to give up part of their company.
When you buy a bond you essentially make a loan to the corporation, the government or whoever else the bond’s issuer might be. Just like when you take out a loan with your bank, the issuer of the bond has to pay interest for being allowed to use your money.
Bonds are determined by three components: the par (or face) value, the coupon rate and the maturity. If an issuer wants to borrow £20,000 for 5 years and is willing to pay 7% interest on this money, the available bond will have a par value of £20,000, a coupon rate of 7% and a maturity of 5 years.
Issuers who want to keep the option of paying back back the face value before maturity, issue a callable bond, while issuers who don’t want to pay interest annually (or quarterly, monthly…) can create a zero-coupon bond. With this type of bond, no interest payments are being made during the loan period but the cumulated interest is paid together with the par value of the bond upon maturity. The advantage of the latter is that these bonds are usually priced at a discount to balance out the fact that no (interim) interest payments are made. This means, to buy a £1,000 bond you might only have to provide funds of £900, but the cumulative interest that you will receive upon maturity is based on the bond’s par value.
The coupon rate of the bond is mainly influenced by the current interest rate, the length of the term and the creditworthiness of the issuer. A company that has a relatively high risk of defaulting (i.e. not being able to pay back the loan) will have to pay higher coupon rates to balance this risk.
Because all of the above determinants can change after a bond is issued, the market value of a bond can and will vary over time. This variation is expressed as a percentage of the par value (i.e. 95% or 102%). Close to maturity, when interest rates and creditworthiness of the issuer won’t have sufficient time to adjust, the bond’s price will converge to 100% par value.
The good news is: if you buy a bond and plan to hold it until it matures, none of the above does affect you in any way. It just gets interesting once you’re trying to sell the bond on the secondary market (i.e. sell the right to receive interest payments from the issuer to some other investor).
More about the factors influencing bond prices soon (in case you don’t intend to hold on to the same bond for 20 years…).
