What are bonds
Bonds are debt securities issued by companies to accumulate funds on the financial market. Thus, e.g. Bayer AG issued a bond to finance the construction of a new factory. In this process, the issuer, in this example Bayer, agrees to repay the borrowed amount at maturity, at a fixed interest rate.
Why don't companies borrow money from banks instead of issuing bonds?
The answer to this question is simple: banks require high levels of collateral to provide a loan. Under certain circumstances, this collateral may only be available to the company to a limited extent or have negative effects on the balance sheet. In addition, the interest rate is usually higher.
It is therefore obvious that companies procure capital on the free market as cheaply as possible and with few conditions.
What are the advantages for bond buyers?
The advantage of buying a bond is the return that the company pays. Of course, it is also important to ensure that not only the possible return is the focus of the decision. A healthy balance between risk and reward should be respected, as it will not do you any good if the outlook for returns is exorbitant, but the risk of bankruptcy is just as high.
Credit standing in focus on bonds
The credit rating is the absolute key factor in bond trading. The better the credit rating, the lower the return and vice versa. As always, opportunity and risk go hand in hand in the financial markets. You have to decide for yourself which risk you are willing to bear and whether the return given will compensate you enough.
As far as the objective rating of a company is concerned, one should inquire in advance about a long-term investment with the local rating agencies such as Moodys and define a threshold for pain that should not be exceeded.
The issue of a bond
A bond is a promissory note that states:
- Time of repayment of the loan (term)
- The interest rate paid per period until maturity
During the maturity of a bond, the buyer can sell the bond at any time to someone else. Due to this ongoing supply and demand situation, the price of a bond is subject to the laws of the market and therefore fluctuates.
When are bonds issued?
Bonds can be issued at any time, depending on the capital needs of companies. The release is usually carried out by a bank designated by the company.
The maturity can range from a few months to decades and is determined by the issuer. Basically, one can state that the maturity has a major impact on the interest paid on the bond. The longer the maturity, the higher the interest, as the risk increases with longer term.
Bond price and interest rate – Negative correlation
As already mentioned, bonds can be bought and sold at any time during the term, which has an influence on the bond price. So you can, for example, buy a bond at a price of 98 and decide 2 months later to sell it at a price of 99.
Price trend of a Bayer corporate bond:
Supply and demand affect the price. The main driver of the demand side is the risk. If the future prospects for a company change adversely, demand will fall and the bond price will fall. At the same time, the interest rate of the new creditworthiness will adjust and rise. In general, it can be said that the interest rate and the bond price run counter to each other and thus there is a very high negative correlation.
It, therefore, remains to be noted that both the interest rate and the price fluctuate during the maturity. However, anyone holding a bond from beginning to end will receive 100% of the fixed interest and capital over this period provided the issuer does not go bankrupt.
Due to fluctuations in the maturity, an effective rate of return may be better than the original interest rate. Here is a comparative example:
- Investment in a 1-year bond from start to finish with an interest rate of 4% and a total investment of €10,000. After one year you have a profit of €400 before tax.
- An investment in a 1-year bond with a residual maturity of 6 months at a price of 99.3 and a 3% interest rate has an annual return of approximately 4.4%, which exceeds the 4% of the first example.
This is how the formula looks like: