When most people think of investing, they think of stocks. Word like ‘stock price’ ‘dividend’ and ‘return’ pop into their head. However, the stock market is not all there is investing. In fact, stocks represent a very, very small portion of the entire market. The debt markets, for example, dwarf the stock markets. In 2011, the size of the global stock markets was $54 trillion. The bond markets reached $93 trillion.
So, what is a bond?
Put simply, a bond is a debt instrument. The bond issuer sells the bond, and promises to repay the money, plus interest to the person who owns the bonds. These interest payments are called coupon payments.
Bonds are primarily used by corporations and government to raise money. For example, if they are fighting a war and need funds, they can issue bonds. There are several features of a bond.
Face Value: This is the amount that the bond issuer will pay at maturity. The face value is comparable to the principal of a loan.
Maturity Date: The maturity date is the date that the face value of the bond is paid to the holder of the bond. The bond issuers debt becomes due on this date.
Coupon Payment: This is the amount that is paid to bond holders before the maturity date, usually in several payments. This payment is essentially an interest payment.
Coupon Rate: The coupon rate of a bond is the ‘interest rate’. It is calculated by taking the coupon payment and dividing it by the face value of the bond. This is also called the yield.
Yield to Maturity: The yield to maturity is the actual return that an investor gets from holding the bond to maturity. If the investor buys the bond at issuance, and holds it to maturity, they will earn the coupon rate. If they purchase the bond in a secondary market, they may get more than the coupon rate, if the bond is trading at a discount, or they will get less than the coupon rate if the bond if trading at a premium.
Bonds are called fixed income securities. This is due to the fact that a bond holder gets a fixed coupon payment at a fixed rate. There is no increasing and decreasing of prices and questionable dividends.
So why do we bother talking about bonds? The answer to this is actually quite simple – you don’t have to hold a bond to maturity. If you want to sell it before then, you are free to do so. Bond’s are priced based on a number of factors. These include the coupon rate, face value and the interest rate environment.
So, unlike stocks, bonds have very strong links to macroeconomic trends such as global interest rates.
Valuing a bond is relatively simple process. As long as you have the yield to maturity, coupon payments and face value. The problem can be getting the yield to maturity. Academically, at least, it is almost impossible without the help of some very sophisticated mathematics.
What will usually happen, is a trial and error approach will be set up, and price discovery will happen using that trial and error approach, based on the yield of other investments with similar risk.
Government bonds, for example, are very safe. So, their yield is going to be similar to the yields of your average savings account or term deposit. Riskier bonds will be rated by a credit rating agency, and the yield to maturity and hence the price can be found in market sentiment at the time.
While stocks may be the most exciting product available in the financial markets, they certainly aren’t the only one. You will struggle to find a big time investor that doesn’t use bonds in some form or another to round out their portfolio.