Bonds are a fixed income investment instrument that are issued by a government entity or a company to obtain financing. This asset class is basically debt issued by a government of a region or a company to try to obtain financing without resorting to bank loans. They are one of the safest assets as they offer us a fixed return, but they also have their risks that we must be aware of. So let's see what bonuses are and how they work.
What are bonuses?
Bonds are a fixed income investment instrument that are issued by a government entity or a company to obtain financing. That is, these assets are basically debt that we buy from a country or a company. The way the bond market works is very simple, the issuer of the bond agrees to return the borrowed capital to the person who purchased the bond on a previously agreed date along with interest, which can be paid regularly or deducted from the capital. initial. The issuance of bonds allows public institutions and companies to obtain a good sum of capital that they could not obtain if they tried to request a loan from a single lender. In this way, the issuance of bonds allows those who issue them to divide the loan amount into different parts (bonds) for whoever wants to invest in them.
Home page of the Spanish Public Treasury. Source: Tesoro.es.
How do bonuses work?
Although it may seem like a difficult asset class to understand, it is simpler than it seems. First the investor buys a bond and The issuer agrees to return the invested capital in a single payment upon expiration of the bond period., which has been agreed upon in advance. By purchasing the bond, the bond issuer agrees to pay an interest rate on the loan. These interests are usually paid in the form of coupons, which are distributed periodically. This way, the investor receives interest periodically and upon expiration of the period you recover your initial investment. Let's take an example to understand it better. If we invest 10.000 euros in a bond with a duration of 5 years that offers us a return of 2%, the issuer of the bond will pay us 2% of the capital invested. When those 5 years pass, we recover our investment with the last coupon we have left to collect. Of course, in some cases the interest paid periodically may be variable, given that it may have indicators such as the Euribor as a reference.
Example of how bonds work.
What is the difference between bonds, bills and State obligations?
The Spanish State issues debt bonds on a regular basis. Of course, the nomination of these differs according to their expiration date. This is because not only bonds are issued, but also public Treasury bills and obligations. Let's see what types of bonds are issued by the Spanish Public Treasury:
- Treasury Bills: These are what we can consider as short-term bonds, which have a duration of one year or less. From the Spanish State they are issued periodically with terms ranging from three, six, nine and twelve months. These Bills are issued at a discount (the acquisition price is less than the redemption price) or at a premium (the acquisition price is greater than the redemption price).
- State Bonds: These are what we can consider as medium-term bonds, which have a duration of between two to five years. Government bond investors receive interest payments periodically through fixed coupons. Right now, the Spanish Public Treasury issues bonds ranging from three to five years.
- State Obligations: These are what we can consider as long-term bonds, which have a duration of more than five years. As we have seen with bonds, State obligations are paid periodically through fixed coupons. Right now the Spanish Public Treasury issues bonds at 10,15, 30, 50 and XNUMX years.
Yield of 1-year bills, 3-year bonds and 10-year obligations of the Spanish Treasury. Source: Tradingview.
What risks does investing in bonds entail?
Bonds are a great way to earn income because they tend to be relatively safe investments. But, like any other investment, they carry certain risks. These are some of the most common risks with these investments:
Interest rates.
Interest rates and bonds don't exactly get along, so when rates go up, bonds tend to go down and vice versa. Interest rate risk arises when rates change significantly more than the investor expected. With an environment of interest rates falling significantly, the investor faces the possibility of prepayment. On the other hand, if interest rates rise, the investor will be stuck with an investment that yields below market rates. The longer the time to maturity, the greater the interest rate risk an investor must bear, because it is more difficult to predict future market developments.
Credit or default.
This risk is more characteristic of corporate bonds than of sovereign bonds. Credit risk or non-payment occurs when interest payments are not made as agreed. When an investment is made in bonds, the issuer is expected to meet interest and principal payments. Therefore, if we decide to invest in corporate bonds, we must analyze the situation of said company to ensure that it complies with its payments. We can verify this by reviewing the balance sheets of the company in question, where we must see that both the operating income and the cash flow are greater compared to the debt it has. If the opposite is the case, we should stay away from those bonds.
Prepaid.
Prepayment is another risk we run when investing in bonds. This may occur when a bond issue is paid before the maturity date through a redemption provision. This can be bad news for investors because the company only has an incentive to pay the obligation early when interest rates have decreased substantially. Instead of continuing to hold a high-interest investment, investors should reinvest their capital in a lower interest rate environment.