👋 everyone,
Lend your money to a government? "Huh?" you might wonder.
Well, that's just a little teaser for this week's topic, which is all about (financial) bonds. Despite their importance in the financial markets, many people know next to nothing about them.
There's a lot of complexity involved in bonds, but for today, let's tackle the basics to get off to a good start!
(Quickly) explained
Bonds are like IOUs. When you buy one, you're essentially lending money to a government or company for a fixed period of time in return for interest.
The money you lend is called the principal, or face value. Over the life of the bond (more on this below), you will receive regular interest payments, called coupons. And you get your principal back at the end of the agreed period.
🤔 Types of bonds
There are several types of bonds available to investors, but the most common are:
Government bonds. IOUs issued by a government to support their spending and obligations. Two examples are Gilts (UK government bonds) and Treasuries (US government bonds).
Corporate bonds. Companies ask people to pool together money for a loan and then aim to repay what they owe from their earnings and cash flow.
🔎 Why do governments and corporations issue bonds? For what exactly?
Well for governments, it might be to fund things like new roads, hospitals 🏥, airports🛫 and other infrastructure critical to supporting and growing the economy.
And corporates issue bonds to raise funding for large-scale projects - such as business expansion, takeovers, new premises or new product development 💻.
Important terms to know:
🫴🏼 Issuer
A bond's issuer is the entity that is issuing the bond. Bond issuers can include, but are not necessarily limited to, country governments, state and local governments, various government agencies, and corporations.
Bondholder
A bondholder is an investor who buys or holds a government or corporate bond.
Par value, also known as face value or principal
Par value is also known as the face value of the bond and is the amount the issuer promises to repay the holder upon maturity (see below for maturity explanation).
📈 Coupons
The coupon is the interest rate paid by the bond issuer and is based on the par value of the bond. For instance, a $1,000 bond with a 7% coupon rate would pay $70 in interest each year.
🕰️ Maturity
The maturity date is the date on which the bond will be repaid in full. This is also the date on which the bondholder will receive the par value of the bond.
💸 Yield
The yield is the return that an investor receives on a bond. It is calculated as the annual interest payment divided by the bond's current market price.
Let's say you purchased a $1,000 bond with a coupon rate of 5%. The annual interest payment, or coupon payment, would be $50 ($1,000 x 5%).
However, let's say the bond's market price has since dropped to $900. In this case, the current yield would be calculated as the annual interest payment divided by the current market price of the bond:
Current yield = Annual interest payment / Current market price
Current yield = $50 / $900
Current yield = 5.56%
So in this example, the current yield for the bond is 5.56%, which is higher than the bond's coupon rate of 5%, since the bond is currently priced lower than its face value. This means that purchasing the bond at the current market price would provide a higher yield than the coupon rate alone.
🫱🏽🫲🏼 Bond market:
The bond market is a marketplace where bonds are traded between investors and issuers.
The bond market is an important part of the global financial system, and plays a significant role in financing government spending, corporate expansion, and infrastructure projects.
📢 Callable bonds
If a bond is callable, this means that the issuer has the option to buy back the bonds at a predetermined date before maturity, if it chooses to do so.
Generally, callable bonds are good for the issuer and bad for the bondholder. This is because when interest rates fall, the issuer chooses to call the bonds and refinance its debt at a lower rate leaving the investor to find a new place to invest.
📝 Credit ratings
In the context of bonds, credit rating refers to an assessment of the creditworthiness of the bond issuer. Credit rating agencies, such as Moody's, Standard & Poor's, and Fitch Ratings, evaluate the issuer's ability to repay the debt by analyzing various factors such as financial strength, operating environment, and industry trends.
Credit rating agencies assign a rating to a bond issuer based on their analysis. The rating typically ranges from AAA (the highest rating) to D (default), and can also include modifiers such as "+" or "-" to indicate a more specific rating within a particular range.
😬 Default
Default occurs when the issuer of a bond is unable to meet its payment obligations.
For example, if a company experiences a significant decline in revenue or profits, it may struggle to make its bond payments.
Bonds explained…in 01:39 mins
🤓 helpful tools!
Interesting fact 🔎
The stock market is huge, but the bond market is even bigger 🤯According to the Securities Industry and Financial Markets Association (SIFMA), the global bond market was worth $126.9 trillion at the end of 2021, compared to the $124.4 trillion global equity market cap.
Thank you for reading and hope you enjoyed. If you did, I’d really appreciate if you could leave a ❤️ , comment or share.
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.