A brief introduction to the world of bonds

 

Bonds are debt securities and thus lower risk assets than equities. While these securities do not offer the potential of stocks, they have other merits. They throw off a certain interest. Bonds with good debt quality are therefore considered conservative investments.

A bond (also called a bond or a bond) is a debt instrument issued by a state, public corporation or corporation to borrow on the capital market. Basically, it is a contract between one of these parties that acts as a borrower (debtor) and an investor who acts as a creditor (creditor). When you buy a bond, you lend the issuer of the bond capital. In return, the borrower promises to repay the borrowed capital at a specific time and to make periodic interest payments until the maturity of the bond (see glossary).

Governments at all levels (in Switzerland, for example, the Confederation, cantons and individual cities) use borrowing loans to cover, for example, budget deficits or to finance the construction of infrastructure projects such as roads, tunnels or railways, while companies absorb the funds they receive for expansion projects such as new production facilities or for acquisitions.

Most investors buy bonds for three reasons: security, income and diversification.

Most investors buy bonds for three reasons: security, income and diversification.

Bonds are an important component of a well-diversified portfolio (see diversification article). Most investors buy bonds for three reasons: security, income and diversification. Because bonds can give your portfolio a certain stability, which counteracts the fluctuation of stocks, and at the same time throw off interest income. Most bonds have a fixed interest coupon, so they are known in jargon as fixed income. Assuming that you are writing a bond for CHF 10,000 with a fixed interest coupon of 4% and a term of ten years, you will receive CHF 400 interest a year during the term and nominal value at the end of the term or at maturity (CHF 10,000) Francs) back. But there are also bonds with a variable interest rate. The variable interest is usually calculated as a pre-determined spread (premium) above a reference interest rate (eg Libor) and redefined after each subsequent coupon payment.

The interest rate of a bond is usually expressed as a percentage of the face value. The amount of the interest coupon depends on the creditworthiness of the issuer (so-called creditworthiness), the interest rate environment and the term of the bond. The maturity of bonds can vary from three months to 30 years and more. As a rule of thumb: Long-term bonds are riskier than short-term bonds and therefore pay higher interest rates. Thus, the investor’s risk is compensated in one piece, since he ties up his investment capital longer and has to wait longer for the repayment of the nominal value.

The bonds issued by the Swiss Confederation are considered virtually risk-free in terms of default risk.

From the point of view of a Swiss investor, the bonds issued by the Swiss Confederation are the safest bonds. These papers are considered virtually risk-free. In other words, it is almost impossible for the Federal Treasury to repay a bond. As a rule, a government bond pays lower interest than a bond issued by a traditional company such as Nestlé or Novartis. Bonds from blue-chip companies, in turn, yield lower interest rates than a bond issued by a medium-sized or small-cap company. For less creditworthy issuers pay a higher interest rate.

The riskiest issuers offer so-called high-yield or junk bonds. Such high-yield securities are bonds issued by borrowers with a low rating (rating), correspondingly higher is the default risk and hence the interest rate of these speculative securities. In general, a default – in addition to inflation – is the biggest risk for bond investors. Concerning inflation, you can remember the following rule of thumb: The higher the inflation, the higher the interest demanded by the investors. This is the only way to ensure that the investor can buy at least as many goods after the investment as before.

At the other end of the spectrum are investment grade bonds. These are bonds from first-class borrowers with a good to very good credit rating. The quality of such a debtor promises a timely interest payment and repayment of the bond.

Interest rates have the greatest impact on bond prices – for example, due to interest rate changes, inflation or counterparty risk. With rising interest rates, the prices of bonds fall. This is because as interest rates rise, new bonds are issued at a higher interest rate, making existing lower-interest-rate bonds less appealing. If you keep your bond to maturity, it does not matter how much the price fluctuates. Your interest rate has been set at the time of purchase and upon maturity, you will receive back the face value (the initial investment) of the bond, provided that the issuer is solvent.

Swiss franc bonds currently show a strong asymmetric risk.

Swiss franc bonds currently show a strong asymmetric risk.

By mistake, quite a few private investors think that they have to hold a bond to maturity. However, you can also buy and sell bonds on the so-called secondary market at market prices. If you sell a bond before its expiration, you run the risk of having to sell the bond at a market price below its nominal value.
Swiss franc bonds currently show a strong asymmetric risk. Many returns are below zero, while at the same time is expected to fall. The yields of Swiss government bonds, for example, are quoted below zero for a period of twelve years. As part of our investment policy, we currently consider franc bonds to be unattractive. Many investors therefore choose “alternative strategies”: they switch to longer maturities, foreign currency bonds or lower credit ratings. In the current environment, this brings substantially higher risks but little additional income. Find out more about the risks involved in buying bonds in this blog post.

So far we have only talked about individual bonds. For example, mutual funds investing in bonds are a bit different: bond funds, for example, have no maturity date, so the amount you invest varies as well as the interest payments that these funds make. Why invest in a bond fund after all? They need a lot of money to build a diversified portfolio of individual bonds. 

Leave a Reply

Your email address will not be published. Required fields are marked *