Macro: Sandcastle economics
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What are bonds? A very brief introduction
John Hardy
Chief Macro Strategist
Bonds are a class of debt securities issued by governments and companies that typically pay out a pre-defined cash flow to holders, called its “coupon”. On their date of issuance, the vast majority of bonds have a maturity date, a date in the future when the bond holder will be reimbursed the full face amount of the bond. That face amount at maturity is called par and is expressed at a price of 100 for the bond, i.e., 100% of the face amount. A bond can trade both well above par and well below par depending on a number of factors, like the size and of its coupon relative to prevailing interest rates, the timing of the coupon payout, and the credit quality of the government or company issuing the bond and other factors.
There are an endless variety of bonds, for example those with coupons that “float” according to changes in the interest rates, inflation-linked bonds, short term bills that are issued below par and don’t pay a coupon, but mature at par, etc. It can all seem a bit daunting to investors not familiar with bonds, or “fixed income” as the professionals call them. But complexity shouldn’t scare investors away from investing in bonds. The vast majority of bonds worth buying for an investor looking for basic income and portfolio diversification, especially those with a medium or higher credit ratings, are quite straightforward in their risk versus expected return profile. That is especially the case in the current environment of significantly positive interest rates, i.e., now that we have exited the zero- and negative policy rate era in most countries.
In order to judge the “quality” of a specific bond, the bond will be rated by a so-called credit rating agency, where the three dominant players are Moody’s, S&P and Fitch. The quality of a bond generally refers to how likely it is that the bond issuer is able to services its obligations to the investor in terms of paying coupons, paying back the loan at maturity etc. Bond ratings are split into two main categories – investment grade and non-investment grade/high yield/junk. Investment grade is high quality bonds where you get a lower return and take on less risk according to the rating, whereas high yield is where you get a higher return and take on more risk.
The different credit ratings from the different agencies can be seen below.
There are an endless variety of bonds, for example those with coupons that “float” according to changes in the interest rates, inflation-linked bonds, short term bills that are issued below par and don’t pay a coupon, but mature at par, etc. It can all seem a bit daunting to investors not familiar with bonds, or “fixed income” as the professionals call them. But complexity shouldn’t scare investors away from investing in bonds. The vast majority of bonds worth buying for an investor looking for basic income and portfolio diversification, especially those with a medium or higher credit ratings, are quite straightforward in their risk versus expected return profile. That is especially the case in the current environment of significantly positive interest rates, i.e., now that we have exited the zero- and negative policy rate era in most countries.
In order to judge the “quality” of a specific bond, the bond will be rated by a so-called credit rating agency, where the three dominant players are Moody’s, S&P and Fitch. The quality of a bond generally refers to how likely it is that the bond issuer is able to services its obligations to the investor in terms of paying coupons, paying back the loan at maturity etc. Bond ratings are split into two main categories – investment grade and non-investment grade/high yield/junk. Investment grade is high quality bonds where you get a lower return and take on less risk according to the rating, whereas high yield is where you get a higher return and take on more risk.
The different credit ratings from the different agencies can be seen below.
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