Bonds are not only found in the portfolios of conservative investors. They also serve as a safety mechanism in stock portfolios in the event that stock prices drop. What are bonds and how do they differ from stocks?
- Bonds are a large volume loan from many lenders.
- The amount of the interest depends on the creditworthiness of the issuer.
- The terms can range from a few months to 30 years.
Definition of the bond
According to digopaul, a bond represents the securitization of a loan. The borrower, the issuer, undertakes to pay the lender, the buyer of the bond, a certain interest rate once a year for a predetermined term. At the end of the term, he buys back the bond.
With regard to the interest payment, there are also special cases:
- The interest is paid twice a year.
- The issue price of the bond is reduced by the interest, the investor receives the full purchase price, and thus also the interest, at the end of the term.
- The interest increases during the term by a predetermined amount.
- The interest rate is based on the development of inflation.
Since, like a pension, the interest payments are regularly recurring payments, bonds are also referred to as annuities.
Market value of the bond
Bonds are issued in a specific currency denomination, for example 1,000 euros, but the value is given in percent. Since most bonds are traded on the stock exchange , they are subject to price fluctuations. These price fluctuations result from the credit rating of the issuer and the respective capital market rates. Suppose an issuer issues a bond in a high interest rate phase. Interest rates are falling. For bonds with better interest rates, the demand and thus the price increases. It is therefore not uncommon for a bond to be listed at 101 or 102. This means that the price is a percentage point or two percentage points above the nominal value. Conversely, it can be the case that an issuer is rated worse by the rating agencies during the term of the bond than at the beginning. In this case, the price drops as the credit default risk increases.
In principle, the amount of the fixed interest rate also reflects the creditworthiness of the issuer.
When issuing a bond, the issuer can choose whether to put the bond on the market at 100 percent of its nominal value, choose a higher issue price ( premium ) or a price reduction ( discount ).
It differs from a stock in that the bond represents a loan, while the stock represents an ownership interest in a company.
What types of bonds are there?
A distinction is made between different forms of borrowing.
The government bond
Government bonds are considered to be the most commonly known form. A state needs money and borrows it in the form of a government bond. The entire wealth of the state, including the tax liability of its citizens, counts as security.
The time after the financial crisis in 2008 has shown that not every country has the same credit rating. The prices of Greek government bonds fell massively, Italy had to pay a relatively high interest rate in order to be able to finance itself. The Finance Minister of the Federal Republic of Germany, on the other hand, earned money by borrowing. German government bonds were so popular with investors because of the high level of security that they entail that the issue price could exceed the nominal interest rate. This in turn reduced investor returns . Security was paramount for the investors.
What applies to states also applies to companies. You refinance yourself by issuing a bond. It is also true for companies that the creditworthiness influences the interest rate.
However , some caution applies to corporate bonds . In 2010, a German bakery chain offered bonds from their company over the bread counter. Papers that are to be placed on the market in this way are part of the gray capital market. Issuers are often medium-sized companies with a “second best” credit rating. The issue is also subject to the provisions of the Securities Trading Act (WpHG), but the risk is significantly higher and trading on the stock exchange is not possible.
Reverse Convertible Bonds
The reverse convertible is a special form of bond. With a classic bond, the buyer receives the nominal value back at the end of the term. In the case of a reverse convertible bond, the issuer has the right to pay the buyer for shares in his company. This converts the original loan into equity. The bond purchaser becomes a co-owner from the lender. Of course, he then has the option of selling the shares and creating liquidity again .
What are bonds?
The term “obligation” is nothing more than a synonym for a bond. The best known are the federal bonds issued by the Federal Republic of Germany since 1979 (Bobl). In contrast to the other government bonds, the term is generally five years. Federal bonds can be tied to the securities identification number (WKN). The first three digits of the WKN are always 114.
The federal bonds are issued in a tender process, an auction. Only banks that belong to the “Federal Issues Bidder Group” are involved. These in turn place the paper on the market via the exchange or pass it on to the customers who have commissioned them to buy. As part of the tender process , the issue price can be above or below the nominal value of the bond.
Buy cheap bonds: find the right portfolio
Anyone who wants to purchase bonds needs a deposit. Fixed-income securities are generally no longer issued as physical securities, but only kept for bookkeeping purposes. The selection of the custody account influences the net return, because the custody account costs reduce the return. Our depot comparison calculator helps to find the best depot for you. The cheapest deposit does not always have to be the best, however, as the personal trading modalities of the investor play a role in the selection of the deposit.
A bond is bought by means of a securities order that the investor gives to his bank. He can note on the order the maximum price up to which the bank should purchase the paper. In addition to a deposit, he also needs a reference account for the transaction . The credit on the reference account must exceed the purchase amount, as the brokerage fee for the bank and the securities broker as well as the stock exchange fees are added to the purchase price of the bond .
The return: are bonds worth it?
This question can not be answered generally. The acquisition of a bond also has to do with the intention of the buyer. Does he just want to invest his money on the safe side and achieve a minimum rate of return? Then he belongs to the group of buyers who achieve an almost negative return on Bunds. If, on the other hand, he would like the highest possible payout every year with high risk, junk bonds and high-yield bonds are the right thing for him. The interest rate factored in the risk of default. Junk bonds are therefore bonds from issuers with extremely dubious credit ratings. The Börsenzeitung gives an up-to-date overview of the ratings of countries. Venezuelan government bonds are classic junk bonds, junk bonds.
Determine the bond yield – this is how it works
On the one hand, bonds have a fixed interest rate, but on the other hand they are subject to price fluctuations. If an investor purchases a bond on the issue date at two percent interest per year at the nominal value and returns it at the end of the term at the nominal value, his gross return would be two percent.
If the same investor buys the bond two years before the due date on the stock exchange at a price of 99 percent, the calculation of the return will be different. He recorded a price gain of one percent. Divided this by two (holding period), results in an increase of 0.5 percent per year. When added to the two percent interest, he was able to record a gross return of 2.5 percent.
Conversely, the return is reduced if the purchase price is higher than the redemption price.
If the investor buys bonds in a foreign currency, the exchange rate development also plays a role in the return, provided he does not invest in the same foreign currency again at the end of the term.
Bond funds or pension funds
The term bond fund rarely appears in the relevant literature; the term bond fund is common . These are open funds that invest investor money almost exclusively in bonds. Depending on the fund description, the fund management may also add shares up to a certain size defined in the prospectus.
Similar to equity funds , pension funds come in a wide variety of forms:
- Regional (country) funds
- The term depends on the average term of the bonds included
- High Yield Fund (funds with high-yield paper)
The investor is free to choose from all conceivable fund compositions (fund allocations).