A bond is a financial instrument made up of two parties, whereby an investor loans out money to a body (either Sovereign or Corporate) which borrows the monies at a pre-determined fixed rate of interest (or variable at times) for a known time period.

Borrowers can either be governments and/or government agencies as well as companies of varying sizes. It is classified as a financial instrument because a bond is a transaction where investors (with cash to invest) lend money to the issuers of the bonds who need to borrow money (usually to maintain ongoing operations, finance new projects or refinance existing borrowings) and is one of the largest group financial assets within global capital markets.

Bonds are generally issued at €100 (or €1,000) which is known as the face value of the bonds and the amount borrowed must be paid back in full at maturity date. One of the most important features of a bond is the coupon (interest rate) which the issuer pays out to the bondholder, which is directly proportional to the risk premium on the bonds, or rather, the compensation the investor wishes to receive for the risk it wishes to undertake by lending money to the issuer of the bond.

Prior to being issued, an investor needs to be made aware of the inherent risks of the bond issue. Most importantly, the investor must have a good understanding of the creditworthiness of the issuer by taking a close glimpse at the issuer’s financial situation, including liquidity, business model as well as be well informed as to why the issuer intends to borrow money.

One of the most common ways of determining the creditworthiness of a bond issuer is by analysing the credit ratings of the Issuer as determined and/or assigned by the reputable Credit Rating Agencies, namely Standard & Poor’s, Moody’s and Fitch.

Credit ratings are generally assigned to the large bond issues on the international bond markets (at the request of the bond issuer) and gives investors a common standard upon which to make a comparative analysis on the financial situation of bond issuers (assuming that credit ratings are updated ongoingly).

A credit rating is a ‘financial score’ given to bond issuers whereby the rating agencies assign a probability, following a thorough analysis on the bond issuer, on whether the bond issuer will be in a position to honour its financial obligations to the lenders/investors and repay the bond principal at maturity or not. Rating agencies continuously revise the company’s credit rating as necessary.

So the concept is pretty basic; the riskier the issuer, the more an investor wants to be compensated in the form of a higher coupon. The less risky the investment, the lower the coupon. So as stated, the risk premium needs to be commensurate with the inherent risk involved with the underlying investment.

As soon as a bond is issued and starts trading, till the time it matures, the instrument becomes tradeable and any yield movement will have an inverse relationship on the price of a bond. Fixed-rate coupon bonds will continue to pay out the same rate of interest on the outstanding amount of the bond till maturity.

However, it is for this reason that the market price of the bond will fluctuate, (based on the common economic concept of demand and supply), depending on a number of factors, primarily the prevailing interest rates at a given point in time, market outlook as well as the changing credit worthiness of the issuer across the lifetime of the bond.

The financial health of a bond issuer might improve or deteriorate throughout the life of the bond and will determine the risks inherent with holding such an instrument and hence is one of the key factors which defines the risk premium (underlying yield at which the bond trades) an investor assigns to a debt instrument.

This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.