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What Is a Bond? And, How Do Bonds Work?

What Is a Bond? And, How Do Bonds Work?

Harry Atkins
28th January, 02:02
Updated: 27th June, 14:57

Whether the aim is stable income in retirement, a specific future cash need, portfolio diversification or old-fashioned risk aversion, or a combination of such factors, an investment in government or private sector bonds merits close attention, the more so in times – like now – of instability in equities markets. In this piece, invezz.com takes a look at what’s on offer for the UK, or UK-focused, investor, the merits of bonds and how one goes about taking a stake in debt.

We start with a pretty basic question, two actually: what is a ‘bond’ and how does it differ from a share?

What is a bond?

Stripped of all the product-specific terminology (including the word ‘stripped’), a bond is nothing more nor less than an acknowledgement of debt and a promise to repay – like an IOU, a cheque, a bank account, or indeed a banknote. Each functions – in law and in fact – as a borrowing of someone else’s money coupled with a binding obligation to repay at some point in time.

How is it different from a share?

What makes the bond different from those other debt instruments is that not only is it evidence of the borrowing and the repayment obligation – and attendant terms – but it also functions as a tradable investment product. There is, generally speaking, no market in IOUs or banknotes – other than as collectors’ items – but there are active markets, worth many trillions of dollars, in bonds, with the major players in benchmarking terms being the bonds recording the borrowings of sovereign states, to fund shortfalls between expenditures and tax revenues.

The other important thing to appreciate about bonds is their difference from equities. The purchase of a listed company’s shares, whether on a market or otherwise, gives the purchaser an ownership interest in the company and, as a general rule, a concomitant right to have a say in key decision-making, via a shareholders’ vote on a resolution. Bonds are not ownership interests and, again generally speaking, bondholders have no say in the company’s affairs. But crucially, bonds take priority over shares in a company’s liquidation, albeit this may prove to be of small comfort if the company is seriously insolvent.

The Language of Bonds

Let’s now address some of the main terms used in relation to bonds and bond trading, some of which are shared with equities but in other instances are the peculiar patois of debt securities.

Bonds – A Combination of Principal and Interest

First up, bonds are issued for a nominal or face value – the amount being borrowed in sterling or other currency – which with wholesale bonds is typically a large amount, such as £50,000, but with retail bonds will be a much smaller amount, say £1,000, £100 or even £1 per bond. Most bond issues are for a set term, with a specified maturity date which may be three-five years (a short-term bond), 10-12 years (a medium-term bond) or for a much longer period, such as 30 years (a long-term bond).

Most bond issues carry a fixed-rate coupon – a specific rate of interest payable at set intervals over the life of the bond, typically bi-annually with government-issued bonds and annually with bonds issued by companies (corporate bonds). But in the UK, especially in the gilts market, a growing number of bond issues in recent years have featured floating-rate or index-linked coupons – the interest rate fixed at the bond’s issue is then adjusted by reference to upwards movement in a specified inflation-tracking index, such as the CPI (Consumer Price Index). And some bonds are stripped after issue – into the principal or face value, which becomes a zero-coupon bond, and the coupons – and traded separately.

A bond is ordinarily sold and purchased cum-dividend which, as with shares, means that the next payment of interest is due to the purchaser, albeit there may need to be a rebate payable to the vendor for the portion of the interest period prior to sale. Where a bond is sold and bought close to the next scheduled interest payment date, typically within the prior week, it trades ex-dividend, meaning that the dividend payment is made to the vendor, less a pro-rata share due to the purchaser for the few days’ interest prior to the interest payment date.

Bond Pricing

A new bond issue typically sells into the market at par, meaning its face value, but if there is sufficient demand, a secondary market will quickly form which will start to price the newly-issued bond. The price of a bond is invariably quoted clean – meaning without regard to the interest accrued to date of quotation – though is bought and sold dirty, as explained in the previous paragraph.

Regardless of their face value, bond prices are generally quoted per 100 nominal, and out to two decimal places. So if bond X is in sterling and is being quoted at, say, 104.56, the price being asked is £104.56 for every £100 of the bond’s nominal value.

Once in the secondary market, bonds rarely remain at par – rather they are bought and sold at either a premium or at a discount, meaning either for more or less than their face value. In the example just given, the bond is being offered at a premium to face value of £4.56, so is a premium bond. But many bonds also sell below their face value, ie they are discount bonds. Whether it’s one or the other is determined by a range of factors but the most influential is the coupon – the interest rate. It is this which determines the accrued value of the bond over its life-time. If the interest rate is fixed, or is anyway assumed to stay the same, a given purchase price will determine that bond’s yield – the rate of return generated by the investment at that price and calculated at that time. It’s yield that determines a given bond’s value, and thus price, versus similar bond issues in the market.

The All-Important Question of Yield

Yield is calculated in different ways, depending on the investor’s needs. First, there is the flat yield, which takes into account only the return generated by the coupon and disregards capital gain or loss on the bond throughout its lifetime. For example, the flat yield on a 4% gilt currently priced at 102.50 would be 3.9%. If the bond’s price rises to 105.75, the flat yield on that bond falls to 3.78%, so demonstrating the inverse relationship between bond yield and price. As a bond’s price increases, its yield falls. As a bond’s price falls, its yield increases.

A more useful, but also more complex, way of calculating yield is to produce for a given bond at the price paid its redemption yield, which can be either gross or net. The gross redemption yield measures the total return that the bond will generate in the period till its maturity and expresses this as a percentage of the bond’s price on an annualised basis. The particular utility of gross redemption yield is that it allows investors to make comparisons in the pricing of bonds with different maturities and coupons. Net redemption yield is a variation which factors in the impact of taxation on the bond’s cash-flows until its maturity.

Impact of Risk Assessment

The price of a bond, and therefore its yield, is not determined only by the coupon – other factors also come into play. The most influential, after the interest rate, is the market’s perception of default risk in respect of either interest installments or capital repayment, or both, for which the credit rating given to that bond by a rating agency is critical. The lowest-risk bonds – those with the highest credit ratings – are issued by central government and are known in the UK as gilts and in the United States as treasury bonds (or T-bills). Bonds issued by municipal authorities and supranational agencies are also likely to be accorded low-risk status, though not as low as central government issues. Corporate bonds – typically though not exclusively issued by listed public companies – are either investment-grade or else they’ve been rated below investment grade, in which case they typically carry a higher interest rate – and are known as high yield or, pejoratively, as junk bonds.

There are other risk factors also priced into bonds on the secondary market, which include market risk – the prospects of the particular bond failing to attract or maintain sufficient, or indeed any, demand – and of course inflation risk – the prospect that the value of the bond’s principal will be eaten away by inflationary forces in the period to maturity.

And with investment-grade corporate bonds, the market always factors in a difference in price between them and gilts, reflecting the perception of higher default risk however small and which is known as the spread. The spread can change from time to time, even as between the same pairing of gilt and corporate bond, which provides one of the several ways in which bond traders look to profit from their dealing in bonds.

Investing in Bonds

So much for the language of bonds. Of course, to invest in this particular investment product it’s not necessary to be an active trader or even to sell at all once the chosen bonds have been purchased. It may suit the buyer of, say, £20,000 in UK gilts paying 5.75 percent and maturing in 2019 to hold the bonds till maturity, reinvesting the after-tax interest payments each year, because in that year their son or daughter will start university and the bond investment will – so that investor anticipates – cover the first year’s fees and expenses.

Trading the Margins

But whilst that particular bond investor will be untroubled by movements in interest rates and inflation over the intervening six years, many other investors aim to stay ahead of the game, as far as achievable, and this means a willingness to buy and sell bonds to best advantage and indeed, to move into and out of bonds by reference to their earnings potential against other investment products, especially equities. First and foremost, bond trading is about margins – the differences, sometimes tiny, in the yields offered by the pricing of a given bond relative to similar products on the market. Exploitation of those differences calls for an active presence on the market.

‘Retail’ Investing

In practical terms, the only way the private citizen – the ‘retail investor’ – can participate directly in the bonds market is at the point of initial issue of a new bond. Once a bond issue has entered the secondary market, there are limited possibilities for direct trading – brokers have the market well and truly covered.

Initial Issues

With a corporate bond issue, the company may decide to offer the issue first to its existing bondholders or shareholders – a form of ‘rights issue’ – or it may offer them to the public at large. In the event of solid demand for the bonds, the company may issue a greater quantity than originally intended (which could of course impact on their price in the secondary market). But typically the company will accept purchase applications direct from the public, though it may also engage brokers to market all or part of the issue. With UK gilts, a new issue is handled by the DMO – the Debt Management Office – arm of the Treasury. In principle, some issues are ‘retail’ to allow ordinary folk to participate in the issue. But given the modern preoccupation with money-laundering and other illegal use of funds, private citizens must have been admitted to the DMO’s ‘Approved Group’ before they can participate in a new bond issue. This involves completing an application form with some pretty personal information required (income, value of assets owned) and at least the prospect of background checks.

The Secondary Market

But once a bond issue is in the market, the only practical way to buy and sell is via a stockbroker. All UK brokers offer a bond broking service – for a fee of course – but some make more of a specialty of it than others, offering complimentary research and analysis, for example, in addition to the straight broking service.

When it comes to buying and selling bonds in the secondary market, meaning once the bond has been issued, there is minimal opportunity for private investors to go it alone. Unlike equities, there are – at least to this point in time – few recognised, or supervised, exchanges for the trading of bonds. The vast majority of transactions take place ‘over the counter’, or more typically ‘over the phone’, amongst broker-dealers – it’s a closed and secretive world, with little in the way of transparency or market accountability, and it’s certainly no place for the private, retail investor.

Theoretically, that investor could look to go it alone, by taking out a subscription to one of the several trading screen programs on the market, which provide access to bond trading amongst other securities. The Bloomberg terminal is an example but it doesn’t come cheap at $1,500 per month for a single screen. Other prominent trading platforms are provided by Thomson Reuters, Morningstar and Dow Jones. But in each case the programs are very much aimed – and priced – at professional traders and brokers. Another key point to be kept firmly in mind is that, in part because of the absence of open, transparent exchanges, many bonds – and especially corporate issues – have poor liquidity, with few trades and the consequential risk that, once in, it may be difficult to get out of the investment.

The LSE’s ORB Market

With such issues – limited ‘retail’ access and illiquidity – in mind, the London Stock Exchange three years ago set up a quasi-retail electronic bond trading exchange, which it calls ‘ORB’ (Order book for Retail Bonds). We say ‘quasi’ because although it’s pitched at non-professional investors, it doesn’t allow any Tom, Dick or Harry to make a trade on any of the listed bonds. As with equities, you have to go through a broker-member of the LSE, of whom some 33 are currently listed as providing access to ORB. But there is an additional feature which brings this bond-trading mechanism closer to direct investor participation – DMA, for Direct Market Access. In the words of the LSE’s explanatory brochure, DMA is “a service whereby London Stock Exchange Members are able to directly submit customer orders to the order book via their own systems.” The advantage for “sophisticated private investors” is that they can “take greater control of their trades by enabling them to place buy and sell orders directly on the London Stock Exchange’s order books.” To this point, just three brokers are listed as offering DMA and no doubt they’re pretty selective in granting this direct investor access via their own trading systems. Walk-ups, we can assume, won’t qualify.

From its launch in February 2010, with just £240 million raised that year, ORB has grown to now include more than 60 gilts and 100 corporate bonds, all with face values of £1,000 or less, and with £1.5 billion raised in participating bond issues in 2012. Of course, to this point the exchange represents only a small fraction of the tens of thousands of bonds on issue but it does afford private, retail investors in the UK, or with an interest in the UK market, to gain insights into representative government and private sector debt securities, and of course to trade them via participating market makers. And ORB-listed bonds now have their very own index – actually there are five discrete indices – courtesy of the FTSE ORB Index Series launched in January this year.

Bond Trading – Groundwork Critical

Actively investing – which is to say, trading – in bonds is not for everyone. Movements in bond prices, both individually and across categories (gilts, municipals, corporates, supra-nationals, junks, and so on) can appear to be capricious and unintelligible in the absence of sophisticated tracking and analytical tools. You can’t turn to the financial pages of your favourite daily and find the latest quoted bond prices. Beyond the listings on ORB, and the few similar systems now emerging in other countries, the bond markets are opaque and inaccessible to other than a select group of market makers.

Yet for investors willing to put in the time and effort needed to understand bonds, how they are priced, the critical importance of interest rate movements in the calculation of yields, the sensitivity of bond issues either generally or case-by-case to changes in both micro and macro-economic and fiscal policies and measures, bonds can be a very attractive alternative to equity securities. At the least, they merit serious consideration for portfolio diversification and hedging purposes.

By Harry Atkins
Harry joined us in 2019 to lead our Editorial Team. Drawing on more than a decade writing, editing and managing high-profile content for blue chip companies, Harry’s considerable experience in the finance sector encompasses work for high street and investment banks, insurance companies and trading platforms.
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