A bond, also referred to as a fixed income security, is a financial instrument whereby an investor loans out money to a sovereign or corporate body, which borrows the monies at a pre-determined fixed rate of interest for a known time period. Borrowers can either be government agencies and/or governments as well as companies of varying sizes and financial strengths Bonds are classified as a financial instrument because the transaction involves the lending out of monies by investors to the issuers of the bonds who need to borrow the money (usually to maintain ongoing operations, finance new projects or refinance existing financial obligations) and is one of the largest group financial assets within global capital markets.
Borrowers can either be government agencies and/or governments as well as companies of varying sizes and financial strengths. Bonds are classified as a financial instrument because the transaction involves the lending out of monies by investors to the issuers of the bonds who need to borrow the money (usually to maintain ongoing operations, finance new projects or refinance existing financial obligations) and is one of the largest group financial assets within global capital markets.
Bonds can be issued in differing currencies and are generally issued at €100 (or €1,000) which is known as the face value of the bonds and the price at which 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 inherent risk premium on the bonds, or rather, the compensation the investor demands 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 underlying 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
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. Also, it is imperative to closely review the legal offering documentation of the said bond issue in order to fully capture the risks of investing in a particular point, particularly covenants relating to bond issues.
Credit ratings (the score relating to the financial strength and sanity of a bond issuer) are generally assigned to the large bond issues on the international bond markets (at the request of the bond issuer) which rating score is a means whereby investors can use a common standard upon which to make a comparative analysis on the financial situation of bond issuers, assuming that credit ratings are updated on an ongoing basis.
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.
It is worth mentioning, however, that credit ratings are backward looking and are based on historical data albeit rating agencies do place some weighting on the outlook of the issuer’s fortunes.
So the concept is pretty basic; the riskier the issuer, the more an investor expects to be compensated in the form of a higher coupon. The less risky the investment, the lower the coupon. It goes without saying then that 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 exchangeable) 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 a 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 in holding such an instrument.
These are few among the key factors which define the risk premium (yield at which the bond trades on the secondary market) 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. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.