A bond is a debt instrument whose issuer receives a sum of money from investors which it promises to reimburse at maturity. The issuer, which can be either a company or a public body (government, agency etc) uses the proceeds of a bond issue to raise funds from lenders amongst the public rather than borrowing from a bank. Bond issues are carried on the balance sheet as liabilities.
The issuer is the sole debtor and faces multiple creditors, who may change over time, according to their decisions to buy and sell bonds in each issue.
The characteristics of the issue (currency, coupon, debtor and maturity, etc.) are established at the time of issue and are included in the prospectus. They are irrevocable and fully binding to all parties.
The creditors (or bondholders) are placed on a strict equal footing with the issuer, regardless of the amount of the debt held, and regardless of the date on which they attained creditor status. Unlike a shareholder, the bondholder has no ownership rights with regard to the borrower.
Unlike shares, whose prices are set on stock exchanges, bond prices are not always as readily available, particularly because they are traded "over the counter" (OTC) without necessarily being posted or recorded by a comparable system. However, quotes by market participants can be found for actively traded bonds. They serve as a reference, but are never regarded as absolute valuations.
Bond prices are fixed as a percentage of a face or par value (usually in thousands).
Example :
100,000 (par) @ 101.00% = 101,000. To this one must add accrued interest and, sometimes both taxes and fees.
Bond prices are sensitive to:
Economic forecasts through figures published by national statistics institutes, economic studies, monitoring studies, individual analyses, and Central Bank rate fluctuations.
Ratings, i.e. the grade accorded the issue by agencies specializing in the study of political risks, budgets, balance sheets etc.
Liquidity or the market’s ability to absorb transactions in the issue. Criteria for this typically is the amount outstanding of the issue, the maturity and the market's appetite for the issuer.
To process a customer’s order, traders have access to various systems ranging from the simple telephone to more sophisticated platforms which enable them to access the market makers who set the prices according to the criteria mentioned above, as well as to their own positions, risk tolerance, authorisations and "gut-feel").
Bonds are regarded as low-risk placements. Though it is true that bonds are less volatile than shares, they do involve other risks:
Interest Rate Risk
Although the investor receives an earnings flow through the coupons and the debt will be reimbursed at par (100%), the price of the bond is subject to the law of supply and demand, varying inversely to the interest rate. Consequently, investors wishing to sell their bonds prior to maturity may have to realise a capital loss if interest rates rise. If interest rates decline, the inverse will occur and the investor will post a gain. This risk is measured by the duration and other options embedded in the issue (derivatives). .
How to protect against this risk:
Hold the debt until maturity
Reduce the duration of the portfolio
Invest in floating-rate bonds
Reinvestment Risk
The reinvestment risk is associated with a reduction of interest rates. In effect, when the yield declines and the coupons or principal are paid, the investor must reinvest at lower rates. Options offering the chance of early redemption increase this risk, which is measured by the average coupon.
How to protect against this risk:
Choose low coupon (zero-coupon) issues
Avoid issues with call options
Avoid issues with sinking funds
Exchange-Rate Risk
Bond markets whose issues are denominated in other currencies may offer higher interest rates than those of the portfolio’s reference currency, thus becoming attractive to the investor. From the moment an investor selects bonds denominated in currencies other than their reference currency, he or she is taking on an exchange-rate risk.
How to protect against this risk:
Diversify currencies
Hedge currency exposure
Include stop losses
Default Risk
Default risk encompasses two kinds of risks, namely the risk of a lowering of the price of the bond with a decline in the debtor’s solvency, and the risk of bankruptcy. This risk is measured by the rating and the differential to swap (or D/Swap).
How to protect against this risk:
Analyse debtor quality
Choose very high-quality debtors
Diversify debtors
Liquidity Risk
Liquidity risk denotes the sensitivity of the bond price when an investor wishes to trade a large amount of an issue. If the price for an amount of five million varies significantly from that of a sum of 100,000, the issue is deemed illiquid. This risk is measured primarily by the bid-ask spread, but also by the issue size and age of the issue.