Investing in bonds
Companies and governments issue bonds to raise money for activities and investments. With a bond you lend money to a company (corporate bonds) or a government (government bonds). A bond is therefore a type of debt instrument.
Characteristics of a bond
- Are valid for a set period, known as the term.
- Are tradable and have a stock price.
- Investors receive periodic interest, usually annually, at a fixed or variable coupon rate.
- Do not provide co-ownership or voting rights, unlike shares.
- Can be bought and sold by investors before their maturity date.
- The issuer repays the full amount at the end of the term, on the maturity or redemption date.
Face value and denominations
The face value of a bond is the amount the issuer wants to raise. This is also known as the principal. It is issued in equal parts, called denominations. You can buy these denominations on the stock exchange, often in units of € 1,000.
An example: for a desired loan of € 500 million, the issuer issues the bond in 500,000 denominations of € 1,000 each. In this way, the bond can be easily traded on the stock exchange and many different investors can invest in it.
Types of bonds
Government bonds
A government bond is issued by a government, usually to close a budget deficit. In the Netherlands, this falls under the responsibility of the Ministry of Finance. Dutch government bonds are issued in euros. There are also, for example, American government bonds (in dollars), German government bonds (in euros), but also bonds from less stable countries in their own currency. The European Central Bank also issues bonds, which are referred to as Eurobonds.
Corporate bonds
A corporate bond generally works in the same way as a government bond. With a company, the risk that the company will not be able to repay the loan is often greater than with a government. This depends on the company’s creditworthiness, about which more later. This risk is reflected in a higher coupon rate.
Special bonds
Special bonds have special features and conditions. Special bonds carry additional risk. Examples are subordinated and perpetual bonds. Special bonds are complex investment products, for which you must first pass a knowledge exam.
Bond funds and ETFs
As an alternative to buying individual government bonds or corporate bonds, there are investment funds and ETFs that invest in multiple bonds at once. As a result, your investment is more diversified.
How creditworthy is the issuing party?
Under normal circumstances, you will get your money back from the issuer at the end of the term. But what does 'normal circumstances' mean? It all depends on the financial health (creditworthiness) of the issuer. If the issuer is in good financial shape, it will pay the interest annually and repay the principal on the redemption date. However, the worse the issuer's financial situation, the more likely it is that they will not be able to pay the interest each year or repay the principal on the redemption date.
Creditworthiness is monitored
To establish whether an issuer is financially healthy, there are special credit rating agencies that rate the bonds. Well-known credit rating agencies are Standard & Poor’s, Moody’s Investors Services, and Fitch Ratings. These agencies use letters and numbers to indicate the creditworthiness of the issuer. AAA is the highest credit rating and C the lowest. A D-rating means the institution is bankrupt.
The ratings tell you the following:
- The higher the creditworthiness, the more certainty you have that you will get your money back.
- The lower the creditworthiness, the more risk you run that you will not get your money back. This higher risk is therefore offset by a higher coupon rate. Since of course you only want to run that higher risk if you expect that you will be rewarded with a higher interest rate.
Investment grade and non-investment grade
The diagram below shows which codes the rating agencies use for creditworthy (investment grade) issuers and for non-creditworthy (non-investment grade bonds or high yield or junk bonds) issuers.
| Sufficient quality to invest in | |
|---|---|
| Excellent credit rating | Moody’s: Aaa Fitch: AAA Standard & Poor’s: AAA |
| Very high credit rating | Moody’s: Aa Fitch: AA Standard & Poor’s: AA |
| Good credit rating. Can deteriorate in bad economic situations. | Moody’s: A Fitch: A Standard & Poor’s: A |
| Sufficient credit rating. Long-term quality will deteriorate in bad economic situations. | Moody’s: Baa Fitch: BBB Standard & Poor’s: BBB |
| Insufficient quality to invest in | |
|---|---|
| At best, these require better than expected economic situations (Ba/BB) to be able to pay in the long term and at worst (D), are bankrupt. | Moody’s: Ba, B, Caa, Ca, C Fitch: BB, B, CCC, CC, C, D Standard & Poor’s: BB, B, CCC, CC, C, D |
The yield on bonds is determined by:
The coupon rate
The term “coupon” dates back to the time when bonds were printed on paper. The coupon rate indicates the interest rate on the bond. You receive the coupon rate periodically (usually annually) on a fixed date (the coupon date).
The price
The price indicates the value of a bond as a percentage of its face value. This does not always have to be the amount that you paid when you bought the bond (your investment).
A bond with a principal of €1,000 and a price of 98% is therefore worth €980 at that time. Redemption at maturity is made at 100% for most bonds. The percentage sign is often omitted when displaying the price.
The term
It goes without saying that a loan must be repaid. The time until repayment (redemption) is the term. The date on which the redemption takes place is called the maturity date. A loan with a longer term carries a higher risk than a loan for a short term. This is reflected in a higher coupon (interest rate).
The development of the yield
Bond prices are constantly changing. This is partly due to the change in interest rates on the capital market, or simply the market interest rate. In general, the following applies:
- If the market interest rate rises, the bond price will fall.
- If the market interest rate falls, the bond price will rise.
How strong this price movement is, depends on the remaining term of the bond:
- The further away from the bond’s redemption date, the more sensitive the bond’s price is to a change in interest rates.
- The closer the bond approaches the redemption date, the more the price will be around 100%. Interest rate developments will have little influence on the price in the latter phase.
In addition, a change in the creditworthiness of the issuer plays a major role. Especially if the creditworthiness deteriorates. This can then lead to a large price drop. This is because it becomes increasingly uncertain whether the issuer can still repay the principal.
Investing in bonds with ABN AMRO
To invest directly in individual bonds, you need an investment account with the Self Directed Investing Plus product. Both Self Directed Investing Plus and Self Directed Investing Basic allow you to invest indirectly in bonds through bond funds and ETFs, which themselves hold multiple bonds.
Investing involves risks
Investing involves risks. You could lose (some of) the money you invested. If you are going to invest, it is important that you are aware of this. Invest with money you can spare. Read more about the risks associated with investments.