What is a bond?
A bond – also known as a fixed-income security – is a debt instrument created for the purpose of raising capital. It is essentially a loan agreement between the bond issuer and an investor, in which the bond issuer is obligated to pay a specific amount of money on certain future dates. Learn more about how a bond works and what rating agencies have to do with it.
Why are bonds an interesting asset class?
Bonds are an attractive asset class that can be very well combined with equities for the purpose of diversification. This is because, historically, bonds generally exhibit lower correlations with the stock market.
Furthermore, from a personal investment perspective, bonds have attractive characteristics as they provide a regular passive income through periodic interest payments.
Different types of bonds:
Corporate bonds (from listed or medium-sized companies),
Government bonds (from developed or developing countries),
Municipal bonds (from states and municipalities), and
Supranational bonds (from promotional and development banks).
When an investor buys a bond, they "lend" this money (the so-called principal) to the bond issuer, who typically uses it to raise funds for a specific project.
When the bond matures, the issuer pays the principal back to the investor. In most cases, the investor receives regular interest payments from the issuer until the bond matures. Different types of bonds offer investors different opportunities.
For example, there are bonds that can be redeemed before their scheduled maturity date, and bonds that can be converted into shares of a company (known as convertible bonds).
Why are bonds referred to as fixed-income securities?
Typically, the unit price of a bond is €1,000, or $ or a multiple thereof. This is also referred to as the nominal value of a bond. A typical bond pays interest on its nominal value twice a year.
These interest payments are also known as coupons. A bond worth €1,000 with a 5% coupon therefore pays €50 per year, or €25 every six months. For this reason, bonds are also called fixed-income securities, as in the simplified example, the payment dates and amounts of the interest are determined in advance.
The interest rate on a bond depends on two things: the term (maturity) and the credit quality. Longer-term bonds generally have higher coupons to compensate the investor for the risk of interest rates rising before the bond matures. This is also known as interest rate risk.
Similarly, lower-quality bonds are equipped with high coupons to compensate investors for the risk of the issuer defaulting or not making payments on time. Credit quality, on the other hand, refers to the issuer's ability and willingness to repay interest and principal on time.
The role of rating agencies
Most bonds have ratings that indicate their credit quality. Rating agencies, such as Standard & Poor's (S&P), Moody's, and Fitch Ratings, provide a service to investors by rating fixed-income securities based on current research and quantifying the risk for the wider capital market using a fairly standardised system.
This rating system indicates the probability of the issuer defaulting on either interest or principal payments, and ranges from AAA (also known as "Triple A", corresponding to a very low probability of default) to D ("Default", meaning a credit default with a very low probability of repayment of the nominal value)*.
* For Standard & Poor's and Fitch Ratings, the lowest tier is "D". For Moody's, the equivalent class to this is called "C", but likewise means the credit default of the bond issuer.