What are bonds? A very brief introduction What are bonds? A very brief introduction What are bonds? A very brief introduction

What are bonds? A very brief introduction

Bonds
John Hardy

Head of FX Strategy

Bonds are a class of debt securities issued by governments and companies that typically pay out a pre-defined cash flow to holders, called its “coupon”. On their date of issuance, the vast majority of bonds have a maturity date, a date in the future when the bond holder will be reimbursed the full face amount of the bond. That face amount at maturity is called par and is expressed at a price of 100 for the bond, i.e., 100% of the face amount. A bond can trade both well above par and well below par depending on a number of factors, like the size and of its coupon relative to prevailing interest rates, the timing of the coupon payout, and the credit quality of the government or company issuing the bond and other factors.

There are an endless variety of bonds, for example those with coupons that “float” according to changes in the interest rates, inflation-linked bonds, short term bills that are issued below par and don’t pay a coupon, but mature at par, etc. It can all seem a bit daunting to investors not familiar with bonds, or “fixed income” as the professionals call them. But complexity shouldn’t scare investors away from investing in bonds. The vast majority of bonds worth buying for an investor looking for basic income and portfolio diversification, especially those with a medium or higher credit ratings, are quite straightforward in their risk versus expected return profile. That is especially the case in the current environment of significantly positive interest rates, i.e., now that we have exited the zero- and negative policy rate era in most countries.

In order to judge the “quality” of a specific bond, the bond will be rated by a so-called credit rating agency, where the three dominant players are Moody’s, S&P and Fitch. The quality of a bond generally refers to how likely it is that the bond issuer is able to services its obligations to the investor in terms of paying coupons, paying back the loan at maturity etc. Bond ratings are split into two main categories – investment grade and non-investment grade/high yield/junk. Investment grade is high quality bonds where you get a lower return and take on less risk according to the rating, whereas high yield is where you get a higher return and take on more risk.

The different credit ratings from the different agencies can be seen below.
 
Graphic of major bond ratings agencies' credit scale

Bills versus bonds

The shortest-term government fixed income securities that mature within a year of issuance are called bills. These are not issued with a coupon, but are instead issued at a discount to par. The interest is paid as a function of the progress toward the price at issuance and the appreciation of the bill’s price as time transpires toward maturity. So, for example, if the 1-year yield is near 4%, a twelve-month US T-bill would be issued just above a price of 96, paying no interest but maturing at 100 on the maturity date 12 months later. If the holder sold the T-bill after six months and interest rates are still near 4%, the seller would realize a price of close to 98, i.e., close to 2% actual appreciation for half a year, or an annualized yield of 4%. 

Floating rate bonds/notes

Floating rate bonds are bonds with a variable coupon. The coupon is typically reset every 3, 6 or 12 months at some level, or spread, relative to a benchmark rate. That benchmark rate is often a short term interbank rate for 3 to 12 months like EURIBOR, ESTR, SOFR, CIBOR, etc., or even a central bank policy rate.

These bonds typically trade very close to par, as the coupons mostly reflect the yields in the market as they are often reset. Floating rate bonds are interesting for investors wanting to receive the short term market yields (like now where yield curve is inverted, meaning that short yields are higher than long yields) while trying to avoid the risk of significant capital losses. This is because floating rate bonds usually are less volatile. Floating rate bonds are also of interest for investors that want to benefit from rising short term interest rates.

Why trade floating rate bonds/notes? The primary reason to consider these is avoiding significant capital losses if you aren’t sure you will hold even shorter maturity bond investments to par, but also if you are very concerned that yields are set to continue rising aggressively. Floating rate notes are available from both governments, local governments (many of these with very high credit ratings) and corporations.

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