Trading: what are bonds and how do they work

26 February 2024 - 17:00

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Fixed-rate, variable rate, subordinated, inflation-linked, and convertible: a complete guide on what bonds are, what types of bonds exist, and how they work.

Trading: what are bonds and how do they work

Bonds are debt securities which give the buyer the right to reimbursement of the principal at maturity, plus accrued interest, paid through the so-called coupon.

Whoever purchases a bond becomes a creditor to the issuer who in turn uses the security to finance himself.

Bonds are notoriously defined as one of the safest investments since, except in the case of bankruptcy of the issuer, upon maturity of the bond the creditor will receive the loaned capital plus the interest accrued during the life of the bond.

In this guide we explain what bonds are, how they work, what they are for, and all the types on the market.

What are bonds

Bonds are debt securities for the buyer and debt securities for the issuer. Through bonds, the issuer promises the buyer - i.e. the person who buys the bond - the entire repayment of the principal at maturity and a return on the capital. The latter represents the yield or the profit that the buyer obtains from the security.

Generally, a higher return corresponds to a higher risk.

How bonds work

Let’s now take an example to explain how bonds work:

  • a company intends to finance itself by issuing a bond, paying less interest than that offered by traditional bank financing;
  • the saver is incentivized to purchase the bond because he enjoys a higher return than the average rate offered by other liquidity investments;
  • the saver can resell the bond on the secondary market or wait until maturity to receive the nominal value of the bond, collecting periodic interest for the entire duration of the bond.

From this simple example we can understand that the value of a bond can vary depending on these characteristics:

  • deadline: is the date by which the debtor (State or company) must repay the capital received.
  • issuer: entity that issues the bond, i.e. the State, company, or entity that contracts a debt through the issue of bonds.
  • coupon: it is the interest that the issuer pays to its debtors, also called bondholders. The coupon can be fixed or variable over time (conditional on the performance of an index or rate). Little curiosity: the yield on bonds is called a coupon because at the beginning the very first bonds were paper and had a coupon that was detached by the buyer and presented at a bank to request payment of the interest due.
  • subscription price: the capital paid when purchasing a bond.
  • nominal value: the capital net of accrued interest that is repaid by the issuer upon maturity of the bond.
  • type of issue: bonds can be issued:
    at par, when the price paid to purchase the bond is the same as the nominal value (i.e. the capital repaid at maturity) net of interest;
    below par, when the subscription price is lower than the nominal value net of interest. This happens for example for BOTs.

Types of bonds

From the issuer’s point of view, bonds can be divided into three main types:

  • government bonds: bonds issued by a state to finance its debt in exchange for the payment of interest. In Italy, BTPs and BOTs are an example.
  • corporate bonds: corporate bonds issued by companies.
  • supranational bonds: debt securities whose issuers are international bodies (such as the World Bank or the European Investment Bank).

In terms of types, bonds can be:

  • indexed bonds: the coupons of this type of bond are linked to the performance of an underlying. Examples are:
    • inflation-linked bonds, linked to the inflation rate,
    • CMS-linked bonds, with coupon flow calculated based on the trend in medium and long-term rates (Interest Rate Swap)
  • zero coupon bonds: bonds that do not provide for the payment of the coupon but for which the issue price is lower than the nominal value, to still result in a return (bonds below par).
  • fixed coupon bonds: the most widespread type of bond of all, a bond that pays fixed interest at a pre-established frequency.
  • convertible bonds: securities that the issuer can convert (transform) into shares.
  • bonds cum warrant: corresponds to the type of convertible bond but the right to convert from bond to share is separable and negotiable on the market.
  • covered bond: bank bonds guaranteed by a part of the issuer’s assets. They have a low-risk profile and high liquidity;

A further distinction is made between variable bonds, which are increasingly widespread on the market. These are structured securities which differ depending on their underlying:

  • fixed reverse floater bonds: bonds usually with long-term maturity which pay fixed and very high coupons in the first period. Subsequently, the coupon obtains a variable rate calculated based on a previously established maximum limit and a variable rate.
  • structured bonds: whose return depends on the performance of an underlying.
    • equity-linked bonds, securities that pay fixed coupons but the overall return on the investment depends on the movements of the underlying,
    • fund-linked bonds, linked to the performance of a basket of funds,
    • commodity-linked bonds, linked to the performance of the raw materials market,
    • forex linked bonds, linked to the performance of the currency market
    • reverse convertibles, with non-guaranteed capital but with higher returns. The redemption at maturity can be of the nominal value or of a quantity of shares whose value is lower than the invested capital.

The risks of bonds

Investing in bonds can involve some risks that need to be aware of:

  • risk of the issuer, i.e. the risk that the issuer does not honor its commitments and does not pay a coupon or does not repay the principal at maturity
  • liquidity risk, for products not listed on an official market such as the MOT or the EuroTLX
  • exchange rate risk, in the case of purchasing bonds issued in currencies other than the euro
  • rate risk, an increase in interest rates will decrease the value of bonds.

Bonds and ratings

The value, and therefore the yield, of a bond is strictly correlated to its rating, or rather the opinion that the rating agencies (Standard & Poor’s, Moody’s and Fitch, among the main ones) give after evaluating the degree of risk in subscribing to this security.
The rating on bonds ranges from AAA, the maximum grade that expresses the absolute best quality and safety, to D, a rating that indicates a very dangerous security that is unlikely to be repaid by the issuer upon maturity.

As anticipated, the degree of risk directly affects the yield of the bonds and therefore the profit that the investor can have by investing in bonds. The riskier a bond is, the higher the yield to still attract investors, despite the possibility that the invested capital will not be repaid at maturity.

Original article published on Italy 2022-07-06 12:59:50. Original title: Cosa sono le obbligazioni

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