Brian BollenThere are a number of things that would-be investors should expect to feature in a trading course about bonds.
These can be broadly broken down into three areas:
- Basic definitions: general explanations
- Basic definitions: specific explanations
- Beyond the basics into analysis of the investment appeal of a bond.
Basic things to know about bonds: General
What is a bond?
The first thing that any trading course on bonds will surely define the word 'bond. A bond is a form of borrowing. A bond is often referred to as an IOU, written by the borrower (also known as the issuer) to buyers (also known as lenders and bondholders).
The nominal value of a bond is known as the face amount, principal or par value. It is this amount which will eventually be repaid (all other things being equal).
When is interest paid?
Interest, also known as the coupon, is normally paid twice a year.
When will a bond’s principal be repaid?
If no other repayment provisions are made, at the end of its tenor is the answer (tenor is financial industry jargon for the number of years the bond is originally issued for, otherwise known as maturity date).
Recently we have seen 100-year bonds issued. There have also been perpetual bonds issued which need never be repaid.
Is it like equity?
No. It is not like equity in that there is no guaranteed share in any improvements in the borrower’s financial position, unless that increases the secondary market value. Bondholders receive interest payments and repayment of the principal sum.
But it is like equity in that the capital raised helps the borrower to function. Perpetual bonds, because they need never be repaid, can be classed in effect as equity. But unlike equity they do not carry votes.
Some forms of bond (for example the contingent convertible bonds created in the wake of the global financial crisis) will be treated as quasi-equity in the event of a financial disaster hitting the issuer. The return to the bondholder should be higher to compensate for that risk.
Who should buy bonds?
Investment specialists will argue that bonds have a place in almost all portfolios. In an ideal world, all asset allocation would be tailored to the needs of the individual investor but that is not yet possible. Unless someone knows otherwise.
Basic things to know about bonds: Specifics
- Who or what is the issuer?
- Is it a public company listed in a major developed market? Or is it a subsidiary of such a company? If a subsidiary, what is the proposed status of the bond in relation to the listed parent? Is there explicit backing from the parent? If so, what form does that backing take? In the absence of an explicit guarantee, do not assume that the parent company's backing is worth having.
- Is it an unlisted company?
- Is it a sovereign state? If a sovereign state, is it a democracy or a dictatorship? None will ever admit it publicly, but once upon a time banks preferred to lend to dictatorships. Because they can ignore the will of the people and so be good long-term credits.
- Is it a quasi-sovereign borrower? That is, a state-owned or state-controlled entity?
- Is it a multilateral multinational borrower, sometimes referred to as a supranational borrower? Examples include the European Investment Bank, the European Union and the International Bank for Reconstruction & Development (also known as the World Bank).
- What is the amount? This is not important only as an absolute number. In the case of a commercial borrower, it must be viewed relative to the borrower's size by market capitalisation, total revenues and profits.
- What is the maturity or tenor? That is, how many years is the issuer hoping to borrow for
- What is the coupon? The coupon is the initial interest rate on offer.
- Is it a fixed rate or a floating rate? If floating, how often is the interest rate reset?
- What is the spread over the benchmark? What is the actual benchmark? How does the spread compare with that paid by similar borrowers? What is the trend in the spread? Rising, falling or marking time? Again, how does that trend compare with similar borrowers?
- What is the status of the bond itself? Is it widely distributed and tradeable? Or is it kept in a small club with the key locked up and thrown away till maturity? Is it a private placement How liquid or illiquid will it be?
- What is the expected issue price? The issue price and coupon determine the initial yield. Once issued, the yield will vary according to market conditions. If a bond's purchase price drops, the yield goes up. If a bond's purchase price rises, the yield goes down.
- What are the proceeds to be used for? To refinance existing debt? To finance an exciting, challenging and inherently risky new venture? For general corporate purposes?
- What are the repayment terms? Are there call provisions for early redemption by the issuer?Are there put options enabling the holder to force the issuer to redeem early? Is there a lottery-style regular redemption plan? Or will it eventually be refinanced by a new bond?
- Is the issue graded? By which agency/agencies? What is the assigned rating?
- What is the trajectory of the rating? Is it improving? Is it deteriorating? Or has it been stable for an extended period?
- Is it investment grade? Investment grade is normally described as having a rating of BBB- or higher by Standard & Poor's or Baa3 or higher by Moody's which have an estimated of 80% of the rating market.
- The other best known rating agency, Fitch, accounts for an estimated 15% or so. Bonds with a lower rating are formally described as high-yield bonds and informally as junk bonds.
Beyond the basics and into analysis: A trading course will stress...
A trading course will stress the importance of having the yield adequately reflect the risk. In 'normal' times this is done by comparing the spread to the rate paid by a borrower such as the US treasury or the UK government or German government for a similar maturity.
In abnormal times such as now, almost anything, it would seem, goes. Serial defaulter Argentina has been able to issue a US$2.75bn 100-year 7.125% bond paying a yield of 8%. This rate proved so attractive to so many investors that it attracted bids of $9.75bn.
Lenders will get their money back in just over 12 years and holders will then start to profit so long as it resists the temptation to default again. If the rates that Argentina can command drop further, holders will be able to sell and book a profit.
Too little for too long
To long-term Latin America watchers, though, it looks too little for too long. Just over a week after the launch, the Argentine treasury warned the economic reforms cited as helping to drive the bond's success would not be implemented as quickly as hoped.
Reflecting the abnormality of markets today, the Ivory Coast recently attracted almost $10bn of bids for $.12bn of 16-year 6.125% bonds and €625m of eight-year 5.125%. The bond was issued less than a month after soldiers staged a four-day mutiny in the African country.
Other questions you need to ask
- Does it match your own investment objectives? Can you afford to buy the bond on current terms? Can you afford to keep the capital committed for the term of the bond?
- Have you had previous experience of the issuer other than buying one of its products or services?
The importance of due diligence
- Have you done credit due diligence on the issuer beyond looking at its debt rating? Or are you relying on the rating assigned by the rating agencies? If relying on their ratings, have you considered how often in recent times they have been proved wrong?
- Have you done commercial due diligence on the issuer to reassure yourself that its business model is sustainable?
- Have you done environmental, social and governance due diligence on the issuer?
- Have you done strategic due diligence to reassure yourself that the business model, if successful, will carry on being followed? Or that if it is unsuccessful, steps are being taken to refocus the issuer?
