What are bonds?: How do saving bonds play a role?

What are bonds?

Each of us borrowed money from our parents, grandparents, or bank to satisfy a current need, money that we repaid sooner or later. The same is true for bonds, which are loans between several creditors (bondholders) and one debtor (issuer). Just as people need money, so do companies or governments need resources for development, in the case of companies or for infrastructure, social programs or to cover budget deficits, in the case of governments.

In the case of bonds, the issuer undertakes to pay creditors an interest (coupon), at certain intervals, for the amount borrowed (face value) until a certain date in the future (maturity). Generally, once the bond matures, the issuer interrupts the payment of the coupons and pays the face value to the creditor. Due to the fact that coupon payments are made at regular intervals and the value of the coupon is already known, the bonds are called fixed income instruments.

Types of bonds, depending on the issuer:

  • Corporate bonds – these are issued by companies, usually for the extension of operations. In addition to the classic bonds that pay the value of the loan at maturity, they can also be convertible or have a call option. In the case of convertibles, at maturity, the bondholder may receive shares in the company in exchange for the amount borrowed. In the case of those with a call option, the issuer has the option to redeem them before maturity at a price announced on the date of issue;
  • Municipal bonds – these are issued by municipalities or county councils to finance investment projects;
  • Sovereign bonds – these are issued by state governments as a rule to cover budget deficits. Generally, no tax is paid on these types of bonds. In Romania, bonds;
  • Supranational bonds – issued by development banks whose shareholders include several states or other international financial bodies (eg BERD, International Investment Bank, Black Sea Trade & Development Bank).

Coupon Bonds:

  • Fixed coupon bonds – these are the most common bonds where the interest rate is constant over the life of the issue;
  • Variable coupon bonds – bonds whose coupon is linked to a money market index (eg ROBOR, EURIBOR, LIBOR, etc.) or those whose coupons are linked to the inflation rate;
  • Zero-coupon bonds – bonds issued below face value (at discount) and which do not make coupon payments. At maturity, the issuer will pay only the face value.

Coupon payment:

  • Quarterly payment 
  • Semi-annual payment 
  • Annual payment

Depending on the priority of the holder:

  • Senior bonds. Senior bondholders have priority in recovering investments when the issuer goes bankrupt / liquidated. Senior bonds carry a lower risk and thus generally pay a lower coupon (interest) than other lower-ranking bonds.
  • Junior bonds (subordinated). Junior bondholders have a lower priority to recover their investment in case the issuer goes bankrupt / liquidated. In this case, junior bondholders will only be paid after all senior credit holders have been paid. Junior (subordinated) bonds carry higher risk and therefore generally pay higher coupons (interest). Banks are the main issuers of junior bonds.

What is the role of saving bonds?

Savings Bonds are interest-bearing bonds issued by the United States federal government. Unlike bonds that are traded on the stock markets, savings bonds are not transferable once purchased and are in this sense non-transferable. Many savings bonds are sold for less than their face value, leaving ample room for interest to accrue over a period of many years. As they represent government bonds, savings bonds are considered one of the safest investments in the world, although their rate of return periodically fluctuates based on prevailing interest rates and inflation data.

The original savings bonds were created by the US government to fund American involvement in World War I. There are two types of savings bonds that are still available; Series EE and Series I bonds. EE Series Savings Bonds pay an interest rate that varies periodically but is calculated as 90% of the average yield on five-year Treasuries over the past six months. In other words, the average yield on a five-year Treasury bond is calculated every six months for the time since the last calculation. If the result is five percent, for example, the new EE series bond yield would be 90 percent of that or 4.5 percent.

This changes for bonds issued in May 2005 or later, which pay a fixed interest rate, somewhat like a certificate of deposit (CD). The EE series bonds are designed to be bought by individuals, as opposed to institutional investors, and their interest is taxed at the federal level only. Interest on savings bonds is calculated monthly but is not paid until the loan is repaid, at which time the interest becomes taxable.

Series I bonds are the second type of commonly issued savings bonds. Their yield fluctuates too, but this is partly based on inflation indices rather than interest rates elsewhere. The other part of the interest paid on a Series I bond is a fixed rate that remains constant throughout the life of the bond. The new rates are calculated in May and November of each year.

What is the role of bonds?

In most cases, bonds are issued to finance investment projects or to cover older loans. Theoretically, an issuer can borrow as much as the market allows, and as long as there is demand for its bonds, there is no upper limit. Issuers usually issue bonds due to lower costs than when accessing bank loans. A bank loan usually imposes certain restrictions on the issuer, such as: not to borrow more than a certain level, not to make purchases, not to pay dividends until after the full payment of the bank loan. Also, in other cases, the need for financing is so great that a single bank cannot finance an entire loan, in which case the issuer can turn to a consortium of banks or issue bonds.

What are the different obligations towards shares? 

The main difference between bonds and equities is that the former are credit instruments and the latter are equity instruments. Through the acquisition of shares, the investor will own a part of the issuer, thus becoming a shareholder. Usually, the holder of a bond receives the interest in the form of a coupon, and the shareholder receives a part of the profit in the form of dividends. 

Both investments, either in equities or in bonds, may result in capital gains or losses, depending on the evolution of the instrument relative to the purchase price. 

Another difference between bonds and shares is the benefit that the issuer has, in the case of bonds, the payment of coupons is deductible from the company’s income tax, while the payment of dividends is a cash outflow and not an expense. 

Because the bondholders are considered creditors, in case of bankruptcy of the company, they have priority in recovering the debts, from the capitalization of the company’s assets in front of its shareholders. This provides an additional guarantee to the bondholder, but the risk is not completely eliminated.

How do you invest in bonds?

There are 3 ways to invest in bonds:

  • On the regulated market or the AeRO market, through a broker
  • On the OTC (over the counter) market, through a bank, like any other banking product. Sovereign bonds are generally available in local banking networks;
  • Indirectly through a bond fund, this product offers a diversification on issuers as well as on maturities, combined with the experience of the fund manager. 

The bonds listed on the stock exchange have several advantages, such as liquidity, transparency, and a strict legal framework. In order to buy listed bonds, you must have an account opened with a broker, where you deposit the amount of money equal to the market price of the bond, plus the commissions indicated by the broker. Generally, when you buy directly from the issuer, during an initial public offering or a private placement, only the face value is paid. But once the bonds are listed, they become the subject of supply and demand and will be valued at the market price. 

Listed bonds have the advantage of liquidity. This means that if a person buys a bond with a maturity of 10 years, but after 5 years he wants his money back, he can sell the bond to another investor, through the Bucharest Stock Exchange. There he will be able to sell it at the market price, which may be higher or lower than the nominal value of the bond. At the same time, this means that an investor has the opportunity to buy bonds from other investors willing to sell, through a broker authorized to trade on the Bucharest Stock Exchange.

Therefore, when you make a direct investment in bonds, you need to know the following: 

  • Commissions – ask how they apply and what their impact is on the total yield obtained;
  • Accrued interest – on the date of purchase you will have to pay the seller the accrued interest (interest accrued from the date of payment of the last coupon until the date of settlement of the bond). Please note that you will receive this accrued interest back on the date of payment of the next coupon. 

The bond investment scenario

When you invest in a bond, you aim to get the highest possible yield (yield/gain), and the lower the price of the bond, the higher the yield. It is important to note that the bonds are traded at prices expressed as a percentage. 

A bond is usually issued at a price of 100% (mainly). We have a bond with a face value of 10,000 RON that we buy at a price of 100% with a 3% coupon, ie a yield until maturity of 3%. 

If the price of the bond drops to 98% and we buy it at this price, then the return on investment will be higher, because that 2% discount is added to the return until maturity. Basically, when we buy a bond, we look at its yield until maturity. 

Very important: yield to maturity can only be achieved under the following conditions:

  • If you keep the bond in your portfolio until maturity. The yield to maturity is based on the assumption that the bond will be repurchased by the issuer at maturity at the price of 100%. If the bond is sold before maturity, then you can get either a capital gain or a loss. Either way will change the actual gain. For example, if you buy a 100% bond and sell it at 110%, you get a 10% difference that brings you a significant increase in real earnings. Conversely, if you buy a 100% bond and sell it at 90%, you will lose 10%, which means that you will earn less than the initial yield until maturity.
  • Received coupons are reinvested (instead of spent) at the same initial yield. Yield to maturity is based on the assumption that in the future the coupons received will be reinvested and never spent until maturity. If you spend on coupons, then you will not get the return until the initial maturity. If you bought a bond with an initial yield of 3% then the future amounts received in the form of coupons must be reinvested in other bonds or the same bond at exactly the same yield of 3%. The longer a bond matures, the higher the risk of losing the original yield. If you are able to invest in higher yields, then the initial yield obtained will be higher.
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By Michael Caine

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