Bonds (also known as fixed interest/income or credit securities), are often misunderstood, and thus, sometimes used by investors for the wrong reason or purpose. Today, we will take a look at the fundamentals and features of these securities, with the aim of building a sound appreciation for this important asset class.
First we will look at an overview of the types of securities that fall under the broad title of bonds and then look at the types of interest that these securities might pay and the different terms or lengths of time that are common for bonds. An overview of the types of issuers and different credit ratings that might be assigned follows, with common features of bonds discussed last.
Types of Securities
Types of Interest
- Debt securities - With this type of investment, the investor is akin to a lender, giving money to another entity in return for interest and eventual repayment of the principal amount. This is usually in the form of a Government bond (i.e. a Government entity needing to borrow money) or a corporate bond (i.e. a business needing to borrow money).
- Asset backed securities (ABS) and collateralised debt obligations (CDO) - Both of these are effectively the 'onselling" of a combination of debts from the original lender to investors. Mortgage backed securities (MBS) have been one of the main securities issued since this type of investment became available, but became unpopular due their significant role in causing the GFC.
- Convertible debt/hybrid securities - This type of security is a debt security with an option included to convert the debt into equity. These investments thus have both debt and equity characteristics and can at times trade more like shares than bonds.
- Fixed - This is the main type of interest paid on bonds, which refers to the rate of interest remaining the same for the life of the debt.
- Floating - Though this asset class is often referred to as fixed interest, variable or floating rates of interest are very common as well, and usually take the form of a premium or margin above a well known reference rate (e.g. LIBOR, 90 day bank bill rate, etc).
- Inflation-Linked - With this type of interest, the rate is generally fixed, but the amount of the bond (principal) rises with inflation. This leads to an increase in total interest paid in inflationary periods. Though this type of bond has traditionally been the sole domain of Government issuers, corporates are also beginning to issue debt that is inflation linked.
Types of Issuers
- Short-term - Commonly referred to as bills (e.g. Treasury Bills, Bank Bills), these securities fall due anywhere from 0 to 365 days (but generally up to 6 months).
- Medium-term - Commonly referred to as notes (e.g. Treasury Notes, Corporate Notes), these securities fall due anywhere from 1 to 10 years.
- Long-term - Commonly referred to as bonds (e.g. Treasury Bonds, Corporate Bonds), these securities fall due anywhere from 10 years and up. Technically, only these type of securities should be referred to as bonds.
- Government - This includes sovereign nations, semi-government, local government and supranationals, all of which may need to raise money due to budget deficits, infrastructure funding or funding of other operations or grants.
- Corporates - This includes most any business entity looking to raise money to finance operations or refinance existing obligations.
- Financials - This mainly refers to banks or other financial institutions who look to package debts into investable securities.
- AAA - This rating refers to issuers or securities that would be seen to be carrying little or no risk (i.e. virtually risk free).
- Investment grade - This mainly relates to corporate bond issuers or securities and refers to their high quality and low probability of default. Different credit rating agencies do have different terminologies and scales, and S&P considers ratings from A to BBB to be investment grade.
- Junk - This refers to bonds that are below investment grade (e.g. below BBB for S&P).
- Options - Bonds can be callable (issuer can buy them back early under certain conditions), putable/redeemable (owner can sell them back early under certain conditions) or convertible (issuer/owner can convert the bonds into equity in the business under certain conditions).
- Covenants - Bonds may come with covenants, which generally place an onus on the issuer to maintain a certain level of financial security (e.g. profitability, low debt, etc).
- Guarantees - Some debts are guaranteed by a more credit-worthy counterparty (e.g. Government, bank, etc) in order to increase the demand for the debt and/or reduce the rate of interest payable.
The structure of a bond or fixed interest security can be quite complicated (as shown above) and it's structure will determine it's price and return. But overall, due to their low correlation with equities and stable income streams, the inclusion of these types of investments within a portfolio is of great importance and should not be disregarded lightly.
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LBW Financial Services Pty Limited is an authorised representative of Wealthsure Pty Ltd, AFSL 238030, ABN 93 097 405 108. The information contained within these articles is of a general nature only. Any rates (tax rates, Centrelink rates, exchange rates, etc) are correct at time of publication and are subject to change. Whilst every care has been taken to ensure the accuracy of the material contained herein at the time of publication, neither the author, authorised representative, nor licensee will bear responsibility or liability for any action taken by any person, persons or organization on the purported basis of information contained herein. Without limiting the generality of the foregoing, no person, persons or organization should invest monies or take action on reliance of the material contained herein but instead should satisfy themselves independently of the appropriateness of such action.