What is a bond and how does it work?  

What is a bond and how does it work?

Among the different investment products, bonds are considered one of the safest investments in the market today. This is why it’s a great option for different types of investors, whether you’re new, looking to diversify, or establishing a steady stream of income.

Let’s delve into the important things you need to know about bonds – what bonds are, the characteristics of bonds, how they work, and the different types of bonds.

What is a bond?

A bond is a fixed-income investment where an investor essentially lends the issuer money for a period in exchange for interest payments and the return of the principal amount upon maturity.

Bonds are generally considered low-risk debt securities because they are issued by governments and corporations, which shows the high degree of stability that guarantee investors will receive regular payments and the principal amount when the bond matures.

However, bonds are not completely risk-free. Their value can be affected by various elements like interest and inflation rates.

Characteristics of bonds

Different bonds possess the same components, but with different characteristics. These characteristics influence each product’s pros and cons, and whether they’ll match your investment goals. Here are the characteristics of bonds:

Face value

Face value (sometimes called par value) is the amount of money that the bond will be worth upon maturity. This is used to calculate coupon payments and the potential returns of the bond.

Issue price

This is the price the investor originally paid for the bond. Depending on the type of bond purchased, the issue price may be at par, on discount, or premium.

Maturity date

The date when the issuer of the bond must pay back their loan. The issuer returns to the investor the principal amount and interest earned.

Yield

The bond’s yield is the rate of return an investor earns if the bond is held until maturity. Hence, it is often expressed as yield-to-maturity. This considers the regular coupon payments, issue price, and value upon maturity.

Coupon rate

The coupon rate is the value of interest that the bond issuer will pay regularly to the bond holder. This is computed against the bond’s face value.

How do bonds work?

Investing in a bond means you are lending money to a government, a government agency, or a company for a specified period. In turn, they promise to return the amount you lent plus interest.

The issuer provides the investor with a bond that contains the terms of the loan, coupon rate, coupon dates, maturity date, and yield-to-maturity. The issuer then gets to use the funds for their projects. Meanwhile, the investor waits for the coupon payments on the specified dates.

For some bonds, the issuer has the option to redeem or sell the bond before maturity. Bonds can be traded in the secondary market through brokers based on prevailing market conditions, interest rates, and the issuer’s credit risk.

7 types of bonds

There are seven different bond types issued by different entities, which have different characteristics.

Government bonds

National governments issue government bonds to raise funds for various projects, such as infrastructures development and social services programs. Given that these bonds are backed by a government’s ability to tax in its territory, government bonds are considered low-risk investments.

There are three sub-categories of government bonds:

Treasury bills (T-bills): These are short-term debt securities with a maturity of up to one year. Investors purchase T-bills at a discounted price and, instead of regular coupons or interest payments, they receive the bond’s face value upon maturity. Their yields are based on the difference between the discounted price and the face value.

Treasury notes (T-notes): These have maturity periods ranging from 2 to 10 years. Investors receive coupon payments every six months, then the principal amount upon maturity.

Treasury bonds (T-bonds): These are long-term debt securities issued by the national government that pay a fixed interest rate every six months until maturity. The Metrobank Peso Retail Treasury Bond’s maturity period is only three years.

Corporate bonds

Corporations that want to raise capital for their business activities issue corporate bonds. Compared with government bonds, corporate bonds carry a slightly higher risk, but are still considered low-risk investments.

With corporate bonds, it’s important to consider who issues the bonds because this dictates the risk it carries. Corporate bonds are classified based on the issuer’s credit ratings, specifically:

• Investment-grade bonds (AAA to BBB ratings): Safer, more stable investments with low risk of default
• Junk bonds (lower than BBB ratings): Higher-risk investments that offer higher yields

Both types of corporate bonds can be good investments, although junk bonds may be more suitable for investors with a higher risk tolerance. Investors with lower risk tolerance would be more comfortable investing in companies with high credit ratings like those we invest in Metrobank Corporate Bond Fund.

Municipal bonds

Municipal bonds are debt securities issued by local governments. These are used to finance infrastructure development and other public projects on the city or municipal level.

These types of bonds are considered low risk but do carry a small risk of default, unlike government bonds.

Most municipal bonds carry a provision allowing the issuer to redeem the bond before its maturity date when market interests are low. This allows the issuer to pay off bonds with higher coupon rates and issue new ones with lower interest rates. However, this provision can be a disadvantage for investors since it will cut off their total income.

There are two forms of municipal bonds:

• General obligation bonds: These are issued by government entities but are not secured by revenue from a government project. These offer higher yields but carry more risk.
• Revenue bonds: These are issued by government entities and are secured by a project’s revenue, usually generated from taxes. This type of municipal bond carries less risk, but yield can vary depending on the revenue.

Sovereign bonds

Sovereign bonds are also government bonds but are issued by a foreign government. Thus, this type of investment can be considered low risk if the bond is issued by a government with stable or developed economies, such as Canada or Switzerland.

In contrast, it can be a risky investment if the issuer has an unstable economy, a high debt burden, and/or a weak currency. The country’s national government may choose to default on its debts or renegotiate the terms of its debts (to lower interest rates or lengthen the maturity period) in case of unfavorable conditions.

Convertible bonds

Convertible bonds are a type of corporate bond that can be converted into shares in the issuing corporation. Other than that, convertible bonds share the same characteristics as corporate bonds, which means that investors may receive regular payments but with a slightly lower interest rate.

Convertible bonds have a conversion ratio that indicates how many shares of common stock they can be exchanged for. The conversion ratio also determines the minimum stock price the company must reach for the bond to be convertible into shares.

Hence, a convertible bond with a conversion ratio of 5:1 with a face value of PHP 50,000 will have a conversion price of PHP 10,000. The company’s stock price must reach this amount for the convertible bond to be eligible for conversion.

Zero-coupon bonds

Zero-coupon bonds are debt securities that don’t pay interest. Instead, investors buy zero-coupon bonds at a discount to the face value. The issuer pays the investor the full-face value upon the bond’s maturity. The difference between the purchase price and the full-face value is the investor’s earnings.

While zero-coupon bonds can be a good long-term investment, they may not always keep up with inflation. Furthermore, higher interest rates can also affect zero-coupon bond’s value in the secondary market. Nevertheless, zero-coupon bonds are a secure investment.

Floating rate bonds

Floating rate bonds are investments with variable interest rates tied to a benchmark, such as the PHP BVAL Benchmark Tenor Reference Rate. These bonds are issued by the government, financial institutions, or corporations. They have a maturity rate of two to five years.

Like other types of bonds, floating rate bonds also offer regular coupon payments but with varying values. The interest rate varies depending on the current interest rates. So, yields have the potential to increase or decrease.

Floating rate bonds can adjust to the fluctuations of the market, so it helps reduce interest rate and inflation risks.

Ready to invest in bonds?

Bonds are a vital financial instrument that allows governments and companies to borrow money directly from investors. In return, bonds offer a secure way for investors to grow their money in the short or long term.

Whether you’re investing for safety and stability or potential higher returns, it’s important to understand what the different types of bonds are, their characteristics, and how they work. With this knowledge, you can be confident in your financial decisions.

Not sure which type of bond to invest in? Don’t hesitate to give us a call.