Bonds

Bonds are probably the most widely used financial instrument by investors as they are considered safer than others, such as the stock market.

What is a bond?

A bond is a security debt issued by an issuing company to finance an asset, with a commitment to paying interest (a coupon) over the life of the loan and to return the entire principal to the buyer at maturity.

In even simpler terms, by purchasing a bond, an investor lends money to the issuing company, which undertakes to pay him an annual amount of interest and to return the money lent at maturity.

Bonds are issued in order to raise capital for investment, directly from savers at more advantageous conditions than bank loans. The advantage for the issuing company derives from interest rates that are usually lower than those it would be obliged to pay by applying for a bank loan with the same maturity.

The two main aspects for the investor are:

• Receiving the payment of an annual interest called "coupon"
• Obtaining the repayment of the invested capital at maturity

Based on the coupon, a bond is classified as:

• with a fixed coupon, the amount of interest is fixed for the entire duration of the bond;
• with a variable coupon, the amount of interest varies from year to year on the basis of a reference parameter that may be financial (such as EURIBOR) or real (such as inflation);
• without coupons, they do not pay interest. They are characterised by the fact that the issue price is always lower than the redemption price. They are known as Zero Coupons.

A bond has three prices:

• issue price, which is the price paid by the investor at the time of subscription and is equal to 100;
• purchase price: this is the price the investor pays to purchase the bond on the market. It can be one of two types: "clean price" if it represents only the value of the capital, "dirty price" if, in addition to the value of the capital, the accrual is also added, i.e., the part of the interest accrued from the last detachment of the coupon until the time of purchase.
• redemption price, is the price at which the bond is redeemed and, subject to exceptions, is equal to 100.

Bonds have a minimum denomination, i.e., a minimum trading amount. Generally, it is 1000 euros (but you might happen to come across higher denominations). This means that, for example, I cannot buy bonds for 58,600 euro, or 58,000 or 59,000. It may seem a trifle, but I assure you that for those who diversify their investment on several issuers, it is not a factor that should be underestimated. In the prospectus, you can find this information alongside all the characteristics of the bond.

As mentioned, bonds are probably the most widely used instrument by investors, given the many advantages they offer. They are:

• Low risk, limited to the possible default of the issuing company and a few other aspects that you will see later on;
• Ductile, they lend themselves very well to any type of investment and financial planning;
• Clear, as they allow you to know, even before purchasing, what their performance will be;
• Give peace of mind, since they are not affected by any collapse of other financial markets, as they always pay the coupon, regardless of anything else;
• They don't need much time spent on them.

But like all things, bonds also have cons. The biggest risks you face by buying a bond are:

• Default: There is a risk that the issuing company will be unable to meet its commitment and pay the periodic coupons and/or repay the principal. This is rare but not impossible (Argentina, Lehman Brothers, Greece...). It is important to check the rating, i.e., the judgement issued by private companies (Moody's, Standard & Poor's, Fitch, etc.) on the ability of the bond issuer to meet its obligations, before proceeding with the purchase.
• Currency: There is a risk if you do not invest in bonds in your own currency, that the yield will be eroded by the exchange rate. Attractive coupons can lead to unpleasant surprises, so you should consider your purchase carefully. If your currency appreciates significantly against the currency of the bond, you risk losing a lot of value on your investment.
• Inflation: There is a risk that the currency depreciation will be greater than the bond's yield. In other words, that the inflation rate will be higher than the annual interest offered by the bond. This is certainly the current case in the United States. One solution may be to invest in bonds indexed to the principal, i.e., that at maturity return the principal revalued by the inflation accrued from the date of accrual (i.e., the day from which interest begins to accrue) to the maturity date.
• Interest rates: There is a relationship between interest rates and bond prices. When interest rates rise, consequently the price of bonds decreases. Conversely, when interest rates fall, the price of bonds rise. However, there is only a risk if you sell a bond before maturity. At maturity, as you have seen, the redemption price will always be 100.
• Coupon distribution: This is not a risk but a flaw that bonds have. Distributing coupons does not allow for the yield to accumulate, that is, for it to be added to the price of the bond. You have to be the one to do this, reinvesting what you receive in the same bond. However, this is not always possible, such as when your coupon is lower than the minimum denomination. And you have seen how important compound interest is to investment.

As I have said, bonds are a very ductile financial instrument that lends themselves well to various financial objectives, the degree of risk, the time perspective or the protection of savings from inflation. They can also be included in more complex strategies, in addition to other financial instruments, as you will see in the penultimate chapter concerning zero-coupon bonds.