Investing in bonds - the basics

Hello everyone,

many of us have one thing in common: we invest our money in the capital market. Be it actively managed funds, ETFs or individual stocks. However, the capital market does not only consist of the products mentioned above, but also of bonds.

I have already come across a few posts on Getquin in which, for example, people asked how bonds work or what they think of them.

I haven't found a post explaining bonds yet. So I want to change that with this post.

The following topics await you in this post:

1) What are bonds and how do they work?

2) Origin of price fluctuations in bonds

3) Risks of bonds

4) What you should pay attention to before buying bonds

1) What are bonds & how do they work?

Bonds are fixed-income securities issued by individual states, companies or banks.

In principle, if you want to put it in simplified terms, the purchase of a bond means nothing other than that you give the issuer (= issuer) of the bond a loan for a certain period of time and in return you are guaranteed certain rights.

As a buyer, you are entitled to two things:

The repayment of the nominal amount (=the money originally invested) at the end of the term. An annual interest payment, the amount of which is already apparent before the bond is purchased.

The amount of interest depends on two factors:

The term of the bond and the credit rating of the issuer.

In general, the longer the term of the bond and the poorer the credit rating of the issuer, the higher the annual interest payment.

2) Origin of bond price fluctuations

Even though bonds are nowhere near as volatile as stocks or ETFs, they also experience price fluctuations.

Price movements are mainly related to the capital market interest rate:

A rising capital market interest rate means falling prices and a falling capital market interest rate means rising prices.

I will explain why this is so with an example:

If someone owns a bond with 10 years maturity, which now has a remaining maturity of 7 years, the bond has a coupon interest of 3.1% p.a. and bought it at par (= 100%), then the capital market interest rate rises and new bonds with higher coupon interest are issued, then the "old" bond falls in price by the difference in interest rates.

A concrete example:

If the newly issued bond has a coupon interest rate of 4.0% p.a., for example. then the bond with a coupon rate of 3.1% falls by 6.3% in price.

The background is quite simple:

The 3.1% bond is not as attractive to investors as the bond with a 4.0% coupon rate because it pays less interest than more current bonds and therefore this is compensated for by a lower price. The remaining term to maturity is multiplied by the interest rate differential: 0.9% x 7 years = 6.3%. So the bond with a 3.1% coupon rate is now 6.3% cheaper and therefore just as attractive as the bond with a 4.0% coupon rate.

Likewise, the example works in the other direction:

We again have a bond with a 10-year maturity that now has a remaining maturity of 7 years. The bond has a coupon rate of 3.1% p.a. and was bought at par (= 100%), then the capital market interest rate falls and new bonds are issued with a lower coupon rate, then the "old" bond rises in price by the difference in interest rates.

A concrete example:

If the newly issued bond has a coupon rate of 2.1% p.a., for example. then the bond with a coupon rate of 3.1% will increase in price by 7.0%.

Again, the background to this:

The 3.1% bond is naturally more attractive to investors due to the higher coupon rate than the bond with a 2.1% coupon rate, and therefore this is compensated for by a rising price. The remaining term to maturity is multiplied by the interest rate differential: 1.0% x 7 years = 7.0%. The bond with a 3.1% coupon rate is now 7.0% more expensive and therefore just as attractive as the bond with "only" 2.1%.

3) Risks of bonds

Bonds also have certain risks that should not be ignored. I will go into three risks in more detail.

Price risk:

The price risk is only "dangerous" for the investor if he wants to sell the bond again before maturity.

The buyer acquires the bond at 100% at the time of issue, for example at a nominal amount of €1000. Now, however, he wants to sell it after six months and the bond has a price of 97%, which means that the investor will only receive 970€ when he sells it and thus makes a loss, so to speak.

Issuer risk:

The issuer of a bond is, as already described above, obliged to pay back the nominal amount to the investor at maturity of the bond and to pay the coupon interest to the investor during the term.

However, the creditworthiness of the issuer could deteriorate to such an extent that it is no longer able to make the coupon interest payment and, in the worst case, can no longer repay the nominal amount.

Inflation risk:

Inflation risk is when one is an investor in a bond whose coupon rate is lower than the rate of inflation. You still have a loss of purchasing power, so to speak, even if it is a bit lower than if you just leave the money in your checking account.

4) What to look for before buying bonds

And now something else I want to point out to you:

Before you buy bonds, you should definitely take a look at the bond terms and conditions. From time to time, there are things in the bond terms and conditions that you should be aware of. What I would like to point out in particular is the issuer's right of early termination.

This means that the issuer can, so to speak, terminate the bond after a certain term, but of course before maturity. You will of course get back the interest and the nominal amount until then, but it is still annoying. Especially the current time is exciting! Because new bonds are issued continuously, due to the current capital market interest situation rather with higher interest rates than with lower ones.

At some point, the time will come when interest rates will not be raised any further. Of course, the issuer has no desire to pay investors the high coupon rate for years. From a purely logical point of view, it naturally makes the most sense for him to call the bonds with the highest coupon interest rate first, so that he can "get rid of them".

It's not a big deal for investors when that happens, but it's annoying in any case, since you'll have to purchase a new bond that usually doesn't have the same coupon rate as the previous one.

This can be prevented by taking a look at the bond terms and conditions.

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That's it for now on the subject of bonds. If you have any questions, suggestions or feedback, feel free to post them in the comments!

Wish you all a nice Sunday and keep your ears stiff :)