The Name’s Bond… Government Savings Bond

Trust gets you killed, love gets you hurt, and bonds make you money.

Have you ever watched a James Bond film and thought to yourself, “Wow, I really want to learn about the fundamentals and classification of fixed-income securities”? Well, then this is your lucky day! Let’s get started with some of the basic definitions and terminologies, then we’ll jump into the real meat and potatoes.

The Basics

Bonds can be thought of as loans that investors give out to institutions like governments and corporations. The borrower, a government or corporation, in this case, agrees to make periodic interest payments on the loaned amount, and then pay back the principal (original amount) in full to the lender at the bond’s maturity date. The original amount is also known as the par value. The par value of a single bond is usually $1,000 or $100. The regular interest payments made on that value are known as coupon payments and have a bi-annual payment structure for the majority of issued bonds. The amount of these payments is entirely based on a bond’s coupon rate, commonly referred to as the nominal bond rate. The nominal bond rate measures the rate of return over one year, or two bi-annual payments. There are some exceptions, but almost all bonds have a fixed nominal bond rate which is set when it is issued and does not change over the course of the bond’s life. The term “coupon” comes from back when an investor would clip off actual coupons from a physical bond document to redeem their payments.

The value of a bond is set based on the principle amount, the going interest rate, expectations of future rates, and the time value of money. We won’t go into the math here, but essentially, investors expect more money in return for waiting longer, which is why the price of a bond isn’t simply the principal plus all of the coupon payments added up.

Imagine if you were selling your house and were offered one million dollars by both Bob as well as Joe, but Bob would pay immediately whilst Joe promises to pay you one million dollars in six months. You would obviously sell to Bob because the value of that million is less in six months than it is now, due to inflation, and getting payment immediately makes more sense. That is, unless Joe offers to pay you enough more to make up for inflation, as well for you to be adequately satisfied in waiting for that long.

The same goes for the pricing of bonds. We’ll be making an entirely separate article about the math that goes into it, so don’t worry about that just yet. Bonds often sell at a premium or a discount to their face value. That’s where the current and expected future interest rates come into play. A bond generally sells at a premium when the interest rate is below the coupon rate, and at a discount when the interest rate is above it. You can imagine how the price of a bond selling at a premium just barely above the current interest rate might change if interest rates are about to drastically increase very soon. Bond valuations have an inverse relationship with the interest rate ceteris paribus (all other things equal).

Risk and Return

The primary risk with a bond comes from the credit default risk of the borrower. Credit rating agencies like Moody’s Analytics and Standard and Poor’s measure that risk for investors, giving every bond a rating on their scales. You’ll be hearing a lot about these ratings, so it’s worthwhile to get familiar with them now. The higher the default risk, the lower the rating, and as you likely intuited, the higher the potential return.

Anything below that red line in the chart is considered to be a junk bond, also known as a high-yield or speculative bond. You may recognize the term if you’ve watched The Big Short, a film about the 2008 Financial Crises. If not, I highly recommend it, but whether you watch it or not, this clip from the movie illustrates junk bonds better than I ever could.

The secondary risk comes from interest rate risk. This is the risk that interest rates will rise after a fixed-rate bond is issued, drastically reducing its value in the secondary bond market, in the case that the holder wishes to sell the bond to a different party before its maturity date. The interest rate risk is the highest for the bonds with the lowest coupon rates, as their valuation is most sensitive to changes in the interest rate.

Government Bonds

Government bonds can be issued by all levels of government to finance spending. These bonds can range anywhere from a T-bill with a 91-day maturity, or very long-term bonds with maturities of up to 30 years. In most developed and stable nations like Canada and the United States of America, these bonds are considered to have zero default risk at the federal and state/provincial levels as they have the entire taxation system backing them. Government bonds are however still susceptible to interest rate risk.

Corporate Bonds

Corporate Bonds are issued by corporations to raise capital, financing business operations. This is the same reason that companies issue shares, though this is known as debt financing whilst the issuance of shares is equity financing. Corporate bonds come with both credit default risk, as well as interest rate risk, though they also have a number of other distinct characteristics that make them very different from government bonds.

What makes the credit default risk a little bit more digestible for investors is bond security. This means that a bond is secured by the pledge of paying the lender in the form of a company asset in the case that it defaults and must liquidate, also known as collateral.

Some bonds are not secured by collateral, and they are known as debentures. Debentures are more often used to raise capital in the short-term for one-off projects that a company must finance, though they are the same as regular bonds in all other aspects. All debentures are bonds, but not all bonds are necessarily debentures.

A convertible bond is another type of specialized bond. A convertible bond can be exchanged by the bondholder at a later date for a set number of shares in the issuing company. This combines features of both a call option, allowing the conversion of an asset into company shares, and a traditional bond. These bonds can be much more attractive to investors, but their values are also much more volatile on the secondary bond market since they are linked to the company’s share price.

Most corporate bonds also come with redeem and call. This is a disadvantage relative to government bonds, as it means the issuing company can recall a bond at any point before the maturity and pay back the bondholder the par value with a slight call premium. The call premium usually does not come close to making up for the lost coupon payments. Companies tend to utilize this ability when interest rates fall too far below the coupon rate, and they do not wish to pay at that rate moving forward.

Zero-Coupon Bonds

A zero-coupon bond is exactly what it sounds like, a bond without a coupon. Many of the zero-coupon bonds on the market are referred to as strips. These are regular bonds with a coupon, that a bank buys and sells the attached coupon separately, leaving just the bond.

Instead of making a return on investment through timely interest payments, you can buy such a bond at a discount to the principal amount. For example, there could be a $1,000 zero-coupon bond with a 10-year maturity that James Bond could buy for $500. The main downside for James to holding the zero-coupon bonds is that he may still have to pay income tax on the allocated interest that accrues annually. This doesn’t mean that James’ $500 is locked away for the next decade however, as he could simply sell it in the secondary bond market. If he did this, chances are that James would earn a profit, as interest rates don’t directly affect the price and the time to maturity would be reduced.

Negative-Yielding Bonds

Negative-yielding bonds are a little bit less intuitive, but it’s possible to make a profit from them as well. A negative-yield bond exists in the situation where a bond issuer is paid to borrow money. Bondholders are made to pay the issuer on coupon dates rather than get paid. Negative yields occur when the bond trades at a premium where the cost is higher than the amount an investor would earn if held until maturity.

Foreign investors are a major contributor for the negative-yield bond market. They buy these bonds believing that the exchange rate to their domestic currency will rise, offsetting the loss. The other reason that investors may put their money into such bonds is that they believe that a period of deflation is imminent, decreasing the yield further, making it worth even more on the secondary market. Remember that bond yield and price has an inverse relationship ceteris paribus, just like bond valuation and current interest rates. Even still, making a profit in negative yield bonds is complicated. Some companies and banks in Europe simply buy negative-yield bonds to meet their liquidity requirements, as depositing results in even more losses, with a -0.5% Euro deposit rate.

Conclusion

For risk-averse investors, bonds are a great way to earn stable long-term returns. For investors like James Bond with a little more of an appetite, the secondary bond market acts as another way to earn money through the use of these securities. Zero-coupon bonds create an opportunity of investment in a security that’s unique in its structure, and perfect for an investor looking for predictability. Negative yields make little sense for the majority of investors, but it’s a good idea to be aware that they exist and know why they are bought.

Key Takeaways

1. Bonds are essentially loans you give to an institution with specified maturities
2. A bond’s original amount loaned is called the principal or par-value and interest payments are called coupons
3. The value of a bond in the secondary market is based upon its par-value, coupon rate, interest rates, and the time value of money
4. Bonds often trade at premiums or discounts to their face value due to credit default risk and interest rate risk
5. Government bonds usually come with little to no credit default risk, whilst corporate bonds can have high risk but can also come with high yields
6. Corporate bonds can be convertible, allowing the bonds to be converted to shares in the issuing company at a later date
7. Corporate bonds can be recalled by their issuer in which case the bondholder would be returned their principal with a slight premium to compensate
8. Zero-coupon bonds are like regular bonds, but without coupon payments, and sell at a discount to their principal
9. Negative-yield bonds exist, but you probably shouldn’t buy any

Next Steps

If you enjoyed this article, be sure to follow these steps to keep in touch with my future projects and articles!

1. Follow me and the InvestBETA publication on Medium for more content like this
2. Be sure to follow @InvestBETA on Instagram for youth-driven investment events and opportunities
3. Connect with me on LinkedIn to hear about my future projects and what I’m up to