When you invest in a bond, you are lending money to the issuer of that bond. The issuer pays you a fixed interest rate over the term of the bond. When the bond reaches the end of its term, the bond issuer will repay you your money.
Good quality bonds, like many government bonds issued in countries backed by strong economies, are relatively safe investments because if you hold them to maturity you enjoy a guaranteed return and have little risk of your money not being repaid.
Parastatals, municipalities, banks and some companies also use the bond market to borrow money.
How bonds work
The issuer asks an investment bank or in the case of the government, the South African Reserve Bank, to structure the bond.
The money the issuer wants to borrow is determined based on the needs of the issuer, and the term of the bond and interest payable is set.
The bonds are then issued through an auction system in the primary bond market and bought by institutional investors such as asset managers and investment banks. In this market, every investor buying a particular bond will pay the same price for each bond issued.
There are different kinds of bonds, but the most common ones are issued for a set amount, and pay a fixed interest rate for the term of the bond. Interest payments are typically made twice a year and at the end of the term of the bond, your capital is returned to you.
Some bonds have very long terms such as 10, 20 or even 30 years.
Interest depends on who the borrower is
The interest rate paid on a bond depends on who is issuing it, for how long, and the current interest rates at which money is being borrowed and lent.
If the issuer is strong and there is little risk that it will default on the interest payments or repaying the bond when it matures, the interest rate will be closer to the rate you could get if the investment has no risk – known as the risk-free rate. Less creditworthy issuers have to pay higher interest rates in order to attract investors.
Governments can raise taxes or print money to repay bonds so they are generally regarded as unlikely to default on their own debt. Other entities may not have the same back-up and so the bonds they issue will have to offer a higher interest rate to compensate for the higher risk.
Bonds with longer terms to maturity are known as long-dated bonds. Investing in these bonds is more risky for investors because they do not know how interest rates, the creditworthiness of the issuer or inflation will change over the term of the bond.
Bonds are rated by credit rating agencies on the basis of the issuer’s creditworthiness. Investment grade bonds are generally of a high credit quality while sub-investment or junk bonds are much more speculative in nature. The creditworthiness of an issuer can change over the life of a bond thereby affecting the credit rating of the bond.
Bonds are traded
Government and other bonds are also listed on a bond exchange. In South Africa the bond exchange is known as the JSE Debt Market.
Institutional investors who have bought bonds in the primary market, can sell these bonds before they mature on the bond exchange. This is what is known as the secondary market.
A bond may be sold for a price lower than the original investment amount if interest rates have gone up since the bond was issued. This is because the income the bond will pay is less valuable than it was when it was issued.
If, however, interest rates have gone down since the bond was issued, investors will be willing to pay more for it than when it was originally listed. This means the price will go up in the secondary market.
It is possible to make good investment gains by buying bonds at a low price and selling when the price is higher, but there is also some risk of not getting that call right.
How do investors make money on bonds?
Investors make money on bonds in two ways:
How can I invest in bonds?
Remember you are most likely to have exposure to bonds in your retirement fund as it is obliged to invest across asset classes in order to comply with regulation 28 under the Pension Funds Act. This is aimed at ensuring your retirement savings are properly diversified. Read more: How are my retirement savings invested?
The risks of investing in bonds
Default
Bond issuers do at times default on the interest payments or repayment of the bond. This will cause the price of the bond to fall rapidly.
However, when bond issuers get into difficulty bondholders' are more likely to get their money back than shareholders.
Most listed bonds are structured so that in the event of the issuer going bankrupt bondholders claims are paid out first. In some cases, bondholders may have to accept a little less than the full repayment or full interest, but they are unlikely to lose all their money in the way that shareholders can.
Interest rate changes
If interest rates rise and you can earn more interest from a new investment than you can from the bond in which you are invested, its value will drop. Even if you hold it to maturity, the interest you will earn will be less than you could earn on other investments. Read more: Who sets the interest rates and how do they affect me?
Inflation
When inflation is rising rapidly, the value of your bond and the interest on it may not keep up. Read more: Why must my investment beat inflation?
Types of bonds
Fixed rate bonds are the most common ones, but bonds may also offer interest that varies with interest rates or inflation.
It is also possible to buy bonds that offer a discount on the face value of the bond and repay the full amount at maturity, or that convert to shares when certain conditions are met.
The bond market lingo
Coupon: This term is not often used any more but it refers to interest payment. The word originates from bonds being issued with paper coupons that investors used to collect their interest.
Yield: This is the effective interest rate that a bond pays based on its price. When the bond is issued it may pay a fixed rand amount in interest at regular intervals. The effective interest rate on issue price of the bond is that fixed interest rate. But if the price of the bond goes up or down in the secondary market, it changes effective interest rate or yield changes.
Duration: This refers to the time period until the bond matures and the sensitivity of the price of the bond to changes in the yield. Bonds with higher durations are more sensitive to changes in the price of the bond.
Yield curve: If you plot the interest rates paid by each bond relative to its term to maturity, normally it makes an upward-sloping curve that is known as the yield curve. This is because bonds with longer terms to maturity will be issued at higher interest rates. The yield curve can, however, change, depending on inflation, the central bank’s monetary policy and the government’s fiscal policy.
