Understanding Bonds - How the Bond Market works

Understanding Bonds in a Nutshell

Understanding BondsBonds are debt instruments. When you buy a bond, you are lending money to the company or government institution issuing the bond for a fixed rate of return. It is, in that sense, bonds are legally sophisticated ‘IOUs’, which can be traded between investors.Typically, in a traditional bond, there is a coupon, which may be regarded as the interest you receive for lending your money. The coupons are paid at fixed intervals, quarterly, semi-annually or annually. As this becomes a source of regular income for the investor, bonds are also known as Fixed Income products.Generally, the greater the risk, the higher the amount of coupon you should receive to compensate you for lending your capital to a borrower with poorer credit quality. Similarly, bonds with longer lending periods tend to have higher amounts of coupon.At the maturity date, which marks the end of the term of the bond, there is a legal obligation on the bond issuer to repay the principal amount invested.

Understanding Bond Terminology

Par value

The par value or the face value of a bond is the amount that the bond issuer has borrowed from the investor.

Coupon

The fixed rate of interest to be paid by the bond issuer to the investor multiplied by the par value of the bond. For example:

Coupon 3% x Par Value SGD 1 million = SGD 30,000 annual interest payment

Fixed Income

The amount received in coupons at regular intervals is the investor’s fixed income per year.

Current yield

Bonds are typically tradeable. As market prices vary from the par value, the current yield of a bond is the annual interest payments of the bond divided by the bond’s current market price.

Callable

This means the issuer can buy back the bonds earlier than the maturity date, paying investors the principal.

Step-up

This means the coupon payable rises on a set date.

Benefits of Bonds

The fixed income
Provided the bond issuer is in good financial standing, bond holders get priority to the bond issuer’s cash flow ahead of shareholders and get paid the coupon at regular intervals.

The repayment of the principal
If the bond issuer is in good financial standing, bond holders will be repaid their principal at the maturity of the bond.

The stabilising effect on a portfolio of financial assets
Compared with stocks which experience higher fluctuations in market price, the promise of fixed income and the eventual repayment of the principal is a stabiliser and a useful diversification tool. For investors approaching or in their retirement years, high quality bonds are useful instruments for preserving capital while generating a stream of regular income.

Legal obligation on bond issuers
Bond issuers must pay bond holders their regular coupon ahead of any payment of dividends to shareholders. In the event of a corporate failure, the bond issuer will have to pay bondholders first before leaving whatever is left to shareholders.

Risks of Bonds

Default risk
The risk of the bond issuer being financially unable to pay the promised coupon, or repay the principal on maturity.

Mark to market risk
When investors need to sell their bonds before maturity, there is the risk they may have to accept prices below the par value of the bonds.

Interest rate risk
While the fixed income of bonds is an attraction, the risk is being locked into fixed compensation for lending your money even when interest rates are rising.

Liquidity risk
It may be difficult to find ready buyers for some corporate bonds. Investors needing to urgently sell their bonds may be forced to accept losses if market sentiment is not favourable.