How do bonds generate a return?
In Topic 1 of this series, we covered the basic concept of bonds along with the different types available. Once your clients have grasped these key concepts, they’ll want to know how they make money from bonds.
In Topic 1 of this series, we covered the basic concept of bonds along with the different types available. Once you have grasped these key concepts, you’ll likely want to know how to make money from bonds.
How bonds generate income
As we discussed in Topic 1 of this series, governments and corporations issue bonds when they need to raise money. In return for buying the bonds, the investor – or bondholder– receives periodic interest payments known as coupons. The coupon payments, which may be made quarterly, twice yearly or annually, are expected to provide regular, predictable income to the investor..
At the end of the bond’s life (known as maturity), the principal is paid back to the investor.
For example, a company may decide to issue five-year bonds with a face value of $1,000 each paying an annual coupon of 4%. The investor will pay $1,000 to buy the bondand, assuming there are no defaults, they will receive:
|Annual coupon||$40 ($1000 x 4%)|
|Total coupons over the life of the bond||$200 ($40 x 5 years)|
|Repayment of principal||$1000|
Factors to consider when choosing bonds for income
There are three key things to consider when choosing a bond as a source of income: the coupon, the credit quality of the issuer and the time to maturity. We will examine each in turn.
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When setting the coupon, the issuer considers the prevailing interest rate environment to ensure the coupon is competitive with comparable bonds and attractive to investors. In line with fundamental investment principles, the couponshould be high enough to adequately compensate the investor for any risks associated with the investment.
With every bond, there is a risk that the issuer could default. This could result in the coupons not being paid or the principal not being fully repaid at maturity. Investors who purchase bonds with low credit ratings may earn higher returns, but they must bear the increased risk of the bond issuer defaulting.
Independent credit rating services assess the default risk of bond issuers and publish credit ratings that help investors evaluate risk. These ratings also help determine the interest rates, or coupon, on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating.
Time to maturity
The length of time it takes for a bond to reach maturity can play an important role in the potential return an investor can expect. An issuer will pay a higher interest rate for a long-term bond because over time there are more factors that can have a negative impact on the issuer’s ability to pay bondholders. For example, a 30-year bond will likely be issued with a higher coupon than a 5-year bond. While the investor will potentially earn greater returns on the longer-term bonds, they also face additional risk. Furthermore, the prices of long-maturity bonds tend to be more sensitive (volatile) to market-wide changes in interest rates than the prices of short-maturity bonds. See Series 1: Topic 5.
Making money from the secondary bond market
Just like shares, investors can buy and sell bonds in a secondary market, where the prices of bonds fluctuate in response to market conditions. Investors can take advantage of these price movements as another way of making money from bonds. The secondary market is examined in greater detail in Series 1: Topic 5 - What impacts the price and performance of bonds?
Investors may be confused about why the price of bonds can change when the face value is fixed. An important distinction to make is that the face value of a bond never changes, while the market price can change daily.