Investing – What are bonds?
Recently I have been taking a (free) course about stock investment. And in a few units we discussed about bond and its components. I think it is a good idea to note down what I learned and hopefully it makes me remember better.
- Bonds, especially government’s, are considered zero risk.
- Bond values are dependent on the reserve bank’s interest rate.
- Don’t look at Current Yield, look at Yield to Maturity figure.
What is a bond?
A bond is essentially a loan of money. Considering company A, they want to finance a project for $500 million dollars. They can go to a bank and borrow that money at 5% interest rate for 30 years. The bank gives them the money and create a loan, but then split that loan into 500,000 bonds, each holds $1,000 in value (this is called par value). These pieces can be sold to investors for, say $1,005 per bond (the $5 extra is called underwriting fee, and that’s how the bank makes money as well).
Once all bonds are sold to investors, the bank is no longer in the picture. Investors and company A will deal with each other directly. Every year, company A will transfer $50 to investors for each piece they hold. Normally it will be splitted to 2 “coupons”, each coupon is $25 and 6 months apart.
After 30 years, company A will then transfer the full amount of the par value back to the bond holders, i.e. the investors.
Government bond behaves exactly the same. We can replace company A with the government, the bank with the Reserve Bank, and the model still works. The reason why government bond is considered zero risk is because the Reserve Bank can print money (or quantitative easing) if needed to pay back its investors.
How to trade them?
There are a list of bonds available here. Which describe the type, when is the maturity date, the interest rate, etc. However, there are only a few stock brokers that can trade them, for example Commsec, CMC Markets, etc. The list can be found in this PDF.
One thing to note is that bonds often have fixed interest rate. Let’s say one that has the coupon yield (technical word for interest rate, or rate of return) of 5%. Then if the RBA interest rate drops lower, its value will go up, since the government will issue new packages with lower rates now, and existing bonds with higher interest rate is considered more profitable. However it goes both ways, if the interest rate rises, existing bonds’ values will go down.
Another thing to remember is that bond value will approach its face value as it approaching maturity date. The reason is once we reach the maturity date, investors will receive the full amount equals to the par value.
Bond yield evaluation
There are 2 ways to look at the yielding value, with simple interest and with compound interest.
We can find the yield simply by dividing the market price into its payment per annum.
As we can see, the yield is lower if we buy with a higher price than its par value, and vice versa.
The calculation above ignores an important aspect of this financial instrument. What happens when the bond matures?
For this calculation, we assume that all coupon payments will be reinvested in something that will return the same interest rate as the coupon yield. And at the maturity date, we also take into account the full returned amount.
As we can see, the Yield to Maturity (technical term for Compounding yield) is much lower than the Coupon yield. Bond market will display both of the rates and it is our job as investors to understand them.
To calculate Yield to Maturity number, you can use this link.
So, when to invest in bonds?
Since bond values goes up if the RBA interest rate goes down, I would say if you expect the interest rate to drop in the near future, they can be a financial instrument worth looking into.
However, most investors look at bond like a low risk investment. This is a great way to preserve wealth and ensure that the capital is secured, and earn a bit of profit along the way.
Bonds are often ignored as its return rate seems to be low. However, if we can utilize its attributes to our advantage, one can actually profit from investing in them and at the same time, preserve his or her capitals.
By Tuan Nguyen