Fundamentals of bond investments

Bonds are essentially loans that investors make to issuers. The issuer may be a government, a semi-governmental agency or a private corporation.

The issuer pays regular interest on the loan and repays the amount borrowed in full to the investors at a specified end date. These features can provide a steady flow of income, which is a key attraction of bonds within investment portfolios.

Bonds versus equities

Bond and equity investments differ in many ways. When investing in equities, you are buying part ownership in a company. This ownership offers unlimited potential for gains in terms of increase in the value of the company shares and the dividends paid.

As long as the company continues to grow and prosper, the value of owning a share of it should continue to rise. The main risks in owning equity investments are that a company can choose to discontinue dividend payments, and the value of stocks can go down, even to zero in extreme cases of bankruptcy or insolvency.

Conversely, a bond investment is a loan and the investor is a creditor to the bond issuer. The issuer is under contractual obligation to pay the bond investor a fixed amount of interest at predetermined intervals and to repay the original amount of the loan at a specified time.

The main risk of holding a bond is that in case of liquidation the company (i.e. the borrower) may not have sufficient assets left to pay back its creditors in full. However, as a creditor, bond investors rank ahead of equity investors.

Therefore, should the company get into financial difficulty the issuer must pay the creditors, including bond holders, first before claiming any of the remains for shareholders. Bonds can lose value if interest rates go up, although they are still considered by some to be a lower risk, less volatile asset class than equity investments.

Risk versus reward

As with any type of investment, there is a trade-off between the risk one is willing to assume and the potential returns. The higher the potential reward, the greater the inherent risk.

The risks associated with different bonds or bond mutual funds can partially be measured by their actual or average credit ratings. The highest rating a bond can have is "AAA" and is primarily reserved for bonds issued and/or backed by highly solvent governments.

Ratings can go down to "C" and bonds rated below "BBB" are considered less than "investment grade" and are otherwise referred to as "junk" or "high-yield" bonds. These bonds typically pay higher rates of interest to compensate for the more risky outlook of the issuer.

Interest rate changes and bond investments

Bond prices and interest rates have an inverse relationship, meaning that as interest rates rise, bond prices generally fall and vice-versa. If interest rates are going up, companies issuing new bonds will be offering a higher rate of interest. Investors buying bonds will prefer receiving this higher interest rate to the lower rates attached to older bonds.

So, if you own an older bond and want to sell it, you will have to compensate a new owner for accepting a lower rate of interest by dropping the selling price of your bond below its original face value, also known as a "discount".

The reverse occurs if interest rates are falling. Your older bond, which is paying higher interest than newer bonds, can now command a higher price, or "premium".

While it is true that rising interest rates can have a negative affect on bond values in the short term, historically, rising rates have not derailed bond investors in the long term.

Bonds in a changing interest rate environment

It is appropriate to consider the type of bonds held within a bond fund at different stages of the economic cycle and interest rate cycle. Government bonds are most susceptible to a rise in interest rates and, in general, more sensitive to macro-economic factors than corporate bonds, where company specific factors tend to be more important. Meanwhile high-yield bonds are less sensitive to changes in the interest rate environment than investment grade corporate bonds and are more likely to benefit from an improvement in the economic outlook.

Mr Kowal is a director of Fidelity International Business Development Unit, UK. Fidelity means Fidelity International Limited, established in Bermuda, and Corp., established in the United States, and their respective subsidiary companies and affiliates. Fidelity Funds SICAV is promoted in Malta by Growth Investments Limited and is licensed by the MFSA.