Overview of a Fixed-Income Security (Bonds)

Who are the issuers of fixed-income security or bonds?

• Supranational organizations
• Sovereign (national) governments
• Non-sovereign (local) governments
• Quasi-government entities

Credit worthiness of Bonds

Bond issuers can also be classified based on their credit worthiness as judged by credit rating agencies.

Bonds can broadly be categorized as

• investment-grade bonds or
• non-investment grade (or high yield or speculative) bonds.

Maturity of Bonds

Fixed-income securities which, at the time of issuance, are expected to mature in one year or less are known as money market securities.

Fixed-income securities which, at the time of issuance, are expected to mature in more than one year are referred to as capital market securities.

Fixed-income securities which have no stated maturity are known as perpetual bonds.

Par Value

The par value (also known as face value, nominal value, redemption value and maturity value ) of a bond refers to the principal amount that the issuer promises to repay bondholders on the maturity date.

Bond prices are usually quoted as a percentage of the par value.

• When a bond's price is above 100% of par, it is said to be trading at a premium
• When a bond's price is at 100% of par, it is said to be trading at par.
• When a bond's price is below 100% of par, it is said to be trading at a discount.

Coupon Rate and Frequency

The coupon rate (also known as the nominal rate) of a bond refers to the annual interest rate that the issuer promises to pay bondholders until the bond matures.

The amount of interest paid each year by the issuer is known as the coupon, and is calculated by multiplying the coupon rate by the bond's par value.

Zero-coupon (or pure discount) bonds are issued at a discount to par value and redeemed at par (the issuer pays the entire par amount to investors at the maturity date).  The difference between the (discounted) purchase price and the par value is effectively the interest on the loan.

Currency Denomination

Dual currency bonds make coupon payments in one currency and the principal payment at maturity in another currency.

Currency option bonds give bondholders a choice regarding which of the two currencies they would like to receive interest and principal payments in.

Yield Measures

The current yield or running yield equals the bond's annual coupon amount divided by its current price (not par value), expressed as a percentage.

The yield to maturity (YTM) is also known as the yield to redemption or the redemption yield.  It is calculated as the discount rate that equates the present value of a bond's expected future cash flows until maturity to its current price.

Given a set of expected future cash flows, the lower  the YTM or discount rate, the higher the bond's current price.

Given a set of expected future cash flows, the higher the YTM or discount rate, the lower the bond's current price.

The calmer waters of interest-bearing investments: their risks and rewards

The interest-bearing investments include:

• cash
• bonds
• the money market securities.

Compared to the roller-coaster ride of equities, interest-bearing investments are like a sea of tranquillity.

The focus of interest-bearing investments is not on the appreciation (increase) of the capital you have invested, but rather on the provision of a steady interest income - often at a fixed rate.

While shares offer you higher returns at a higher risk, interest-bearing investments offer you lower returns at a lower risk, making them a safe haven for many investors.

But this safe asset class is not safe from inflation. 

Interest-bearing investments often do not generate the kind of return that beats inflation, and it is very important to remember that interest income is taxable.  After taking tax into account, the return on interest-bearing investments often struggles to beat the inflation rate.

The reason for this is simple.  Interest-bearing investments are normally money you lend to a bank, government, company or other institution with the undertaking that this exact amount will be paid back after a period of time. 

In return for this, you earn interest.

Since you only get the same amount back after a couple of months or years, that amount is usually worth less as a result of inflation. 

Your only real benefit is the income that you receive.

Interest-bearing investments also hold other risks. 

• This asset class is subject to the ups and downs of the interest rate cycle.  As interest rates increase or decrease, your cash flow can be affected - unless you have a fixed interest rate.
• Furthermore, you should beware of institutions with credit risk.  A high interest rate is not everything:  you must also be sure that your capital will be paid back. 

The so-called junk bond market in America is well known as a market where companies with poor credit ratings offer exceptionally high interest rates.  Sometimes it is better to earn less interest, but know that your money is safe.

Interest-bearing investments do, however, play an important part in an investment portfolio.  Although inflation will still erode the capital value of your investment, these investments do have advantages, including:

• offering you a relatively safe and predictable income.
• offering you less risk and volatility than an investment in equities
• offering diversification in your portfolio in case stock markets collapse
• giving you instant access to cash when you need it.