How Do Bond Investments Work?

As you start investing and building your wealth, you will at some point consider investing a portion of your money in bonds. So, if you have ever asked yourself, “What Is A Bond” and “How Do they Work?”, then keep reading. I wrote this specifically for you to answer these core questions about bond investing. 

Therefore, following post is a basic overview of what bonds are. Specifically addressing: how bonds work; who (and by whom) they are issued; what makes bonds attractive investments; and some major considerations you’ll want to factor into your decision before allocating capital to bonds or similar income securities to your portolio. 

What Is A Bond?

In the simplest terms, a bond is a loan made to a company or government  that pays back at a fixed rate of return over a specified time frame.

For instance, a KES. 100M goverment bond with a 10-year maturity date and a coupon rate of 12% would pay KES. 12,000,000 a year for a decade, after which the original KES.100M amount (face value) is paid back to the investors. Since, bonds provide regular payment over a specified period, say KES. 12M a year, they are commonly referred to as fixed-income securities.

Here is a the simple math underpinning the above example assuming that  an investor that invests KES.500,000 into the bond mentioned above: 

Key measures for assuming a KES. 500M bond investment

• Fixed Rate = 12%
• Annual Interest = KES. 60,000
• Payment Frequency = yearly (to simplify the math, usually the Kenyan goverment bonds may pay quaterly or semi annually)
• Payment Value = KES. 60,000
• Total interest for the bond held for 10 years = KES. 600,000

*initial payment, investor buys the 12%,10-year fixed-income bond.

**final payment, the issuer pays back the pincipal with the final coupon rate. 

***final coupon payment

The Different Types of Bonds & How They Work

The exact details of a bond vary with each bond.

A bond is simply a contract written up between the issuer (borrower) and the investor (lender), whereby any legal provision upon which they might agree could theoritically be put into the bond indenture (bond contract). 

In broad terms, over time there have been certain ordinary customs and patterns that have emerged over time, where the following types of bonds emerge: 

Sovereign Bonds

Sovereign bonds are bonds issued by a sovereign goverments, in this case Kenya. These could be treasury bills, bonds and notes which are backed by the full faith and credit of the country, including the power to tax in order to meet its constitionally required obligations.

Additionally, governments often issue special types of bonds aside from the usual to meet a specific mandate or need. For instance, the EuroBond or Infrastucture Bonds (like M-Akiba), are special types of bonds. We also have agency bonds like the infrastructure bonds. They are issued by goverment agencies with the assumption that they are fully backed by government itself and often offer higher yields. 

Municipal Bonds

Municipal bonds are bonds issued by the local goverment like the KES.5B county bond issued by Laikipia County.  These bonds tend to be tax-free for two main reasons: 

• In order to allow local goverments to enjoy lower interest rates that would otherwise have been high, thus freeing up money for other county projects;
• And to encourage investors to invest in civic projects that improve civilization such as funding roads, bridges, schools, hospitals and more. 

Corporate Bonds

Bonds issued by corporations, partnerships, limited liability companies and other commerical enterprises, and often offer higher yields than other types of bonds. However, the tax for these bonds isnt favorable. Investors may part with upto 10%-25% of total interest income to Kenya Revenue Authority (KRA). 

Examples of Corporate bonds with NSE ): 

Major Considerations of Bond Investing

There are various major considerations of bond investing that you need to factor in before allocating capital to fixed-income securities to your portfolio. These considerations include:

• Risk i.e. how much risk can you handle?
• Allocation i.e. how much to allocate to bonds and other investments.
• Diversification factors for your portfolio. 

Q. What Are the Main Risks of Investing In Bonds?

Risk is one major factor in bond investing.

Though bonds are generally considered less risky then stocks, they do have their own elements of risk which include: 

Credit Risk

Credit risk is essentially the probability of not receiving your initial (principal) investment or interest back at the contractually guranteed time due to the issuer’s inability or unwillingness to do so. Credit risk is managed by sorting bonds into groups based on likelihood of default. Ranging from investment grade bonds to junk bonds.

This rating is conducted in the international bond market by the independent agencies: Standard & Poor, Moody’s Investors Service and Fitch Rating Inc. These agencies tend to rate higher bonds with a low chance of default, as it is assumed that the lower the interest rate the lender will recieve the lower the chance of default.

Typically, investors are more than willing to pay a higher price for low risk bonds as measured by various financial ratios such as number of fixed obligations covered by net earnings of a company, cashflow or interest coverage ratio. Companies that are doing well and have high net earnings, healthy cashflows and high interest coverage, thus have a better rating and also tend offer lower interest. 

Inflation Risk

This is the chance that the government of a given country will enact policies that may lead to a widespread inflation. For example, should the Kenyan government agency increase fuel prices, the general cost of living will increase as well. 

A higher rate of inflation will destroy your puchasing power and thus rendering your principal insufficient by the time you get it back at maturity of the bond. This is why certain bonds have built in protection or variable rates to reduce the risk of holding such a bond. 

Liquidity Risk

Bonds are less liquid than a majority of stocks, this means that once you get them, you may have a difficult time selling them at a good price. This is the main reason why it is always best to restrict the purchase of individual bonds for your portfolio to bonds you intent to hold until they mature. 

To provide a real-life illustration, lets take a look at the bond statistics on the NSE. 

Assume we held the bond, FXD 1/2013/10Yr, which is a 10 year bond issued in 2013, maturing in 2023 whose and priced at 109.6710 as at 12th September, 2019. If we put out a bid request to sell this bond, the best price we would probably get is 107.7630 (which is the price on 13th Septepmber, 2019). At this price, it would be unwise to part with the bond. 

This price spread in bonds isn’t unsual and that this why it is always best to trade bonds in larger blocks that smaller ones in order to get better bids from large insitutions. 

Reinvestment Risk

When investing in bonds, there is always the risk you will not be able to reinvest the interest income paid regularly (as offered by some bonds). This may be so if interest rates have dropped considerably, and thus you will have to place your interest income to work in bonds with lower returns that you had been enjoying before. 

Therefore, because you cannot predict ahead of time the precise rate at which you will be able to reinvest the money, reinvestment becomes a risk the investor needs to contend with. 

Q. How Much of Your Portfolio Should Be Invested In Bonds?

Knowing what is the proper bond asset allocation you need for your portfolio will be based on how much risk you can handle. The basic rule of thumb you can use (if you feel it fits your situation) is for: 

1. Retirement, “own your age” that is if you are 30 years old, invest 30% of your portfolio in bonds and 70% in stocks.  
2. A risk-taker, hold 110/120 minus your age in stocks and the rest in bonds i.e. 80% – 90% in stocks and gradually, shift your portfolio to bonds over time. This strategy assumes that as a young investor, you have time to recover from losses in the stock market and thus can take advantage of the higher returns offered. 

Overall, there are guidelines and then there is you. Determining the allocation of your portfolio involves many factors such as how long you intent to invest for, your risk tolerance, your financial future goals, perception of the market and also income. 

What is A Bond Fund?

A bond fund is a pooled structure (either traditional mutual fund or EFT) that invests in bonds and other debt securities. Typically, bond funds pay periodic dividends that include interest payments on the funds invested in the various securities plus periodic realized capital appreciation. Investors who don’t want the hustle of investing in individual bonds but still want to hold fixed-income securities in their investment portfolio, tend to invest in bond funds.

Why Should You Invest In Bonds?

• If you have a large cash reserve far in excess of Kenya Deposit Insurance Corporation (KDIC) insurance requirements, the best place to park the funds, is in treasury bills, bonds and notes. 
• Bonds offer a predicable return and tend to outperform the stock market in certain economic cycles. 
• Bonds are better than a bank as they offer better rates. 

Key Things You Need to Know

• Government bonds are generally considered the safest investment. They are backed by the full faith and credit of the goverment. 
• A bonds interest rate is tied to the creditworthiness of the issuer. Thus great companies offer lower interest while as sketchy ones will offer higher interest rates. This is because of the increased risk  that the company may fail before paying off the debt. 
• Bond funds are very volatile because they do not have a fixed price or interest rate since they invest in many different types of bonds of different types. 
• It matters how long you hold a bond for as bonds are sold for a fixed term. Therefore, should you sell your bond before its maturity date, you run the risk of not making back your original principal investment.
• Bonds tend to lose market value when the market interest rate rises as the resale value of an older bond stuck at a lower interest rate becomes unattractive to investors.  
• Avoid investing in foreign bonds whose inherent risk you do not understand.

Image credit: Top by Rawpixel via Pexels. 

With the knowledge of bond basics under your belt, read on to learn more about:

• 5 of the Biggest Investment Benefits of M-Akiba
• How to Make Money Investing in Unit Trusts