Many people are curious about the fact that municipal investment standard bonds have a 30-year track record of zero defaults. What exactly are bonds? Today, I have summarized and compiled a detailed explanation, hoping it will be of help to you.
Bonds are financial contracts issued by governments, financial institutions, industrial and commercial enterprises, and other entities directly borrowing from society to raise funds. They promise to pay interest at a certain rate and repay the principal under agreed conditions. Bonds have basic characteristics such as repayability, liquidity, safety, and income.
The essence of a bond is a certificate of debt, which has legal force. The relationship between the bond buyer or investor and the issuer is a creditor-debtor relationship, with the bond issuer being the debtor and the investor (bond buyer) being the creditor.
Definition and Classification of Bonds:
Bonds are debt certificates issued by issuers to bond investors to raise funds, promising to pay interest at an agreed date and rate in the future, and to repay the principal on an agreed date.
The nature of a bond is that it is a valuable security. Since the interest on bonds is usually predetermined, bonds are a type of fixed-interest security, and the mainstream varieties can be traded on the market.
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It should be noted that the term "interest predetermined" refers to the bond's coupon rate.
After bonds are traded on the market, a market interest rate, which is the secondary market price, will be determined by market transactions and will fluctuate with market conditions.
Thus, bonds encompass the following three meanings:
1. The issuer of the bond (government, financial institution, enterprise, etc.) is the borrower of funds.2. Investors who purchase bonds are the lenders of funds.
3. The issuer (borrower) is required to repay the principal and pay interest within a certain period.
Basic elements of bonds:
1. Face value, also directly referred to as "par value," is the monetary value indicated on the bond's face, which refers to the amount that the bond issuer promises to repay to the bondholder on the bond's maturity date. It is the principal value of the bond, meaning that it indicates how much money the bondholder will receive on the day the bond is fully matured if the issuer does not redeem the bond or defaults.
2. Coupon rate, also known as the nominal rate, refers to the ratio of the bond's annual interest to its face value and is the calculation standard for the interest payments that the issuer promises to pay over a certain future period. The coupon rate is calculated by dividing the total annual coupon payments by the bond's face value.
3. Issue date, the date when a company or government issues the face payment to the bondholder.
4. Maturity date, the date on which the bond should be redeemed, assuming there are no special circumstances.
5. Term to maturity, the time from the issuance of the bond until the date it should be repaid with principal and interest, and also the total time limit for the bond issuer to fulfill their contractual obligations. Typically, bond issuers list the term and interest rate of a particular bond to investors through prospectuses or issuance announcements.
6. Issue price, refers to the price at which bonds are publicly issued in the primary market, which is usually the same as the face value but not necessarily. When the issue price is higher than the face value, it is called a premium issue; when the issue price is lower than the face value, it is called a discount issue; and when the issue price equals the face value, it is called a par issue.
7. Trading price, refers to the transaction price at which investors transfer bonds in the secondary market. Generally, the less active the trading (fewer people wanting to buy or sell in the secondary market) and the poorer the liquidity of the bond, the lower the trading price.8. Yield (Yield to Maturity), the actual interest rate if you buy a bond today and hold it until maturity. If the bond price falls, the yield will increase (because the bond's return is measured against the lower current bond value), and vice versa.
9. High-yield bonds, bonds given a low credit rating by rating agencies. High-yield bonds are also known as junk bonds because their yields are typically higher than those of investment-grade bonds with higher credit ratings. They carry more risk than investment-grade bonds, which is why their yields are higher.
10. The issuer's name corresponds to the creditor of the debt, which not only clarifies the issuer's obligation to repay the principal and interest to the creditor but also provides a basis for the creditor to recover the principal and interest upon maturity.
Sources of Bond Returns:
The profitability of bonds is mainly manifested in two aspects. First, investing in bonds can bring regular or irregular interest income to investors. Second, investors can take advantage of bond price fluctuations to buy and sell bonds and earn the difference.
Specifically, there are three main sources of returns: interest income, capital gains, and reinvestment income.
✓ Interest income. In other words, it is the "coupon payment," and the level of the coupon depends on the coupon rate. For example, for a bond with a face value of 100 yuan issued with an agreement to pay interest once a year at a coupon rate of 7%, the interest would be 100 * 7% = 7 yuan.
✓ Capital gains. The face value of a bond is fixed, but the bond price will fluctuate with market changes. The difference between the bond's purchase price and sale price is the capital gain, and investors earn this part of the return by "buying low and selling high" to "earn the difference."
✓ Reinvestment income. This part of the income is often forgotten by investors. It refers to the interest income earned during the investment period in bonds, which is obtained through reinvestment. Essentially, it is "interest on interest," commonly known as "compound interest."
Classification of Bonds:1. Categorized by Issuing Entity
① Government Bonds
Government bonds are bonds issued by the government to raise funds. They mainly include national bonds, local government bonds, etc., with the most important being national bonds. National bonds are also known as "gilt-edged bonds" due to their good credit, favorable interest rates, and low risk. In addition to bonds directly issued by government departments, some countries also include government-guaranteed bonds in the government bond system, known as government-guaranteed bonds. These bonds are issued by companies or financial institutions directly related to the government and are guaranteed by the government.
② Financial Bonds
Financial bonds are bonds issued by banks and non-bank financial institutions. In our country, financial bonds are mainly issued by policy banks such as the China Development Bank and the Export-Import Bank. Financial institutions generally have strong capital strength and high creditworthiness, so financial bonds often have good credit.
③ Corporate/Enterprise Bonds
In our country, corporate bonds are bonds issued and traded in accordance with the "Regulations on the Administration of Corporate Bonds" and are supervised and managed by the National Development and Reform Commission. In practice, the bond issuers are institutions affiliated with central government departments, wholly state-owned enterprises, or state-controlled enterprises, so they largely reflect government credit.
The regulatory body for corporate bonds is the China Securities Regulatory Commission, and the bond issuers are corporate legal entities established in accordance with the "Company Law of the People's Republic of China." In practice, the issuers are listed companies, and their credit protection is based on the quality of the issuing company's assets, operational status, profitability, and ability to sustain profits. Corporate bonds are uniformly registered and held by the Securities Depository and Clearing Corporation and can apply for listing and trading on the stock exchange. Their credit risk is generally higher than that of corporate bonds.
However, there is often no clear distinction between corporate bonds and enterprise bonds.
2. Classified by Property Collateral
(The translation for this part is not provided in the original text.)1. Mortgage Bonds
Mortgage bonds are bonds secured by the property of a company, which can be further classified into general mortgage bonds, real estate mortgage bonds, chattel mortgage bonds, and securities trust mortgage bonds. Those secured by real estate such as buildings are known as real estate mortgage bonds; those secured by movable property such as marketable goods are called chattel mortgage bonds; and those secured by valuable securities like stocks and other bonds are referred to as securities trust bonds. In the event of a default by the bond issuer, the trustee can sell and dispose of the collateral to ensure the priority claim of the creditors.
2. Credit Bonds
Credit bonds are bonds issued without any company property as collateral, relying solely on credit. Government bonds fall into this category. These bonds have a solid reliability due to the absolute creditworthiness of the issuer. In addition, some companies can also issue such bonds, known as corporate credit bonds. Compared to mortgage bonds, the holders of credit bonds bear a higher risk, thus often demanding a higher interest rate. To protect the interests of investors, companies issuing these bonds are often subject to various restrictions, and only those large companies with an outstanding reputation are qualified to issue them. Moreover, protective clauses must be included in the bond contracts, such as prohibitions on mortgaging assets to other creditors, mergers with other companies, selling assets without the consent of creditors, and issuing other long-term bonds.
3. Convertible Bonds
Convertible bonds are bonds that can be converted into common stock at a fixed ratio within a specific period, possessing dual characteristics of stocks and ordinary bonds, and belonging to a hybrid financing method. Since convertible bonds grant bondholders the right to become company shareholders in the future, their interest rates are usually lower than those of non-convertible bonds. If the conversion is successful in the future, the issuing company achieves the goal of low-cost financing before the conversion, and after the conversion, it can save on the issuance costs of stocks.
4. Non-Convertible Bonds
Non-convertible bonds are bonds that cannot be converted into common stock, also known as ordinary bonds. Since they do not grant bondholders the right to become company shareholders in the future, their interest rates are generally higher than those of convertible bonds.
5. Classification by Issuance Method
(Please provide the details for this category as it was not fully translated in the original text.)1. Publicly Offered Bonds
These refer to bonds that are publicly issued to the market, available for purchase by any investor, and are publicly raised from an unspecified majority of investors. They can be transferred on the securities market.
2. Private Placement Bonds
These are bonds raised from a select few investors who have a specific relationship with the issuer, and both their issuance and transfer have certain limitations. The issuance procedures for private placement bonds are relatively simple, and they generally cannot be traded on the securities market.
The distinction between publicly offered bonds and private placement bonds is not pronounced in the European market, but in the bond markets of the United States and Japan, this distinction is very strict and also very important.
5. Based on the maturity period of the bonds, they can generally be divided into short-term bonds, medium-term bonds, and long-term bonds. Bonds with a term of 1 year (inclusive) or less are called short-term bonds, bonds with a term of 1-5 years (inclusive) are called medium-term bonds, and bonds with a term of more than 5 years are called long-term bonds.
6. Based on the interest rate, they can generally be divided into fixed-rate bonds, floating-rate bonds, and variable-rate bonds.
7. Based on whether they contain rights, they can be divided into non-rights-bearing bonds and rights-bearing bonds. The options included in rights-bearing bonds include issuer options and investor options, among others.
8. Based on the interest payment method of the bonds, they can be divided into zero-coupon bonds, periodic interest payment bonds, and bonds with a lump-sum repayment of principal and interest at maturity.
① Zero-coupon bonds refer to bonds where the issuer does not pay any interest during the bond's term and repays the bond at its face value on the maturity date.② Regular interest-paying bonds typically pay interest to investors on a quarterly, semi-annual, or annual frequency;
③ Zero-coupon bonds are those that specify a coupon rate at issuance, but do not pay interest until the maturity date, at which all interest accrued is paid along with the principal.
How do bonds work?
When a company or government wants to raise funds to finance new projects, maintain operations, or refinance maturing bonds, they issue bonds. This is essentially a loan, so when investors purchase bonds, they are lending money to the company or government that issues the bonds. Each bond has a maturity date and interest payment terms.
Interest payments are generally referred to as coupons, and because the length of the lending commitment increases, long-term bonds typically pay higher coupons. Bonds are usually traded over-the-counter (OTC), and they have a face value, also known as par value. When a bond is traded at a price below its face value, it is said to be trading at a discount. When a bond is traded at a price above its face value, it is said to be trading at a premium.
At issuance, the price of a bond is generally set at its face value. Over time, the price of a bond will change, and the main driver of these price movements is the change in interest rates. There is an inverse relationship between interest rate changes and bond prices. If interest rates rise, bond prices generally fall. If interest rates fall, bond prices generally rise.
Other factors, such as changes in credit quality, also affect the price investors are willing to pay for bonds. If a bond issuer's credit rating is upgraded, investors will typically be willing to pay a higher price for that issuer's specific bonds than before, because the perceived risk is lower. This usually leads to an increase in bond prices. Conversely, if the credit rating is downgraded, investors will perceive the issuer's bonds as riskier and will demand a higher potential return. This usually leads to a decrease in bond prices, as the risk of holding downgraded bonds is higher.
Some bonds are callable, which means that the company or government can redeem them before maturity, usually at a specific price. Other bonds are putable, which means that bondholders can force the issuer to repurchase the bonds at a specific price.
Interest Rate and Bond Price Example
To understand the inverse relationship between bond value and interest rates, consider a bond with a face value of $1,000 issued at an interest rate of 4%. This means that a $40 coupon (4% of $1,000) will be paid annually to the bondholder.If later the interest rate rises from 4% to 5%, new investors can now earn an annual interest of $50 from a new bond with a face value of $1,000 of the same maturity. As a result, the bond that previously paid only $40 in annual interest appears to be much less attractive than the bond paying $50 in annual interest.
For this reason, investors will no longer be willing to pay $1,000 for a bond that pays only $40 in interest each year. Instead, they will demand to purchase this less attractive bond at a lower price.
Pros and Cons of Bond Investing:
Like all types of investments, investing in bonds also has its advantages and disadvantages.
1. Advantages
Diversification: Bonds can add diversity to an investment portfolio and are safer and less volatile than some other investments.
Interest: Bonds provide regular interest income, which is often recommended for retirees who rely on interest income to cover their living expenses.
Bond prices may rise: This can sometimes occur due to flight-to-quality buying.
Note: Not all bonds carry the same level of risk. Corporate bonds are riskier than government bonds, although there are also differences in risk within corporate bonds themselves.
2. DisadvantagesInterest rate fluctuations can reduce the value of some bonds.
Affected by market risk and credit risk volatility.
There is an inverse relationship between bond prices and interest rates. The bonds held by investors always have the potential to depreciate, and companies may redeem bonds when interest rates fall in order to secure more attractive rates on newly issued bonds.
Tip: One of the greatest benefits of bonds is their ability to pay interest regularly.
How to calculate bond yield: To calculate the yield of a bond, investors divide the annual coupon payment by the bond's price.
Bond yield = Annual coupon payment / Bond price
As long as the selling price of the bond changes, the yield will change. For example, if an investor buys a bond at a face value of 1,000 yuan, which pays 100 yuan annually over 10 years, the yield in this case is 10%. However, if the investor sells the bond at a price of 800 yuan, the actual yield will increase to 12.5%. (=100/800)
Main types of bonds
Bonds are mainly divided into the following types based on the issuer:
I) Government bonds1) Treasury Bonds
These are bonds issued by a country's Ministry of Finance, with the government's fiscal revenue serving as the source of repayment. In our country, treasury bonds are divided into book-entry treasury bonds, certificate treasury bonds, and savings treasury bonds.
2) Central Bank Bills
These are bills issued by a country's central bank, which are essentially central bank bonds. In our country, central bank bills are short-term debt certificates issued by the People's Bank of China to commercial banks to regulate excess reserve funds.
3) Local Government Bonds
These are bonds issued by a country's local governments, with the local government's fiscal revenue as the source of repayment.
4) Government Agency Bonds
These are debt certificates issued by government departments other than the central government, government-sponsored enterprises, and related institutions.
5) International Financial Organization Bonds
These are bonds issued by international multilateral financial organizations such as the World Bank, the Asian Development Bank, and the European Bank for Reconstruction and Development.
6) Financial Bonds
These are bonds issued by financial institutions.Financial bonds refer to valuable securities issued by financial institution legal entities established in accordance with the law within the People's Republic of China in the national interbank bond market, which are repayable with principal and interest as agreed. Financial institution legal entities include policy banks, commercial banks, corporate group finance companies, and other financial institutions.
7) Non-financial corporate bonds
Non-financial corporate bonds refer to bonds issued by various enterprises other than financial institutions. In China, they can be divided into super short-term financing bills, short-term financing bills, medium-term notes, small and medium-sized enterprise collective notes, corporate bonds, and corporate bonds, etc., according to different trading venues and regulatory authorities. Among them, super short-term financing bills, short-term financing bills, medium-term notes, and small and medium-sized enterprise collective notes are collectively referred to as non-financial corporate debt financing instruments.
8) Asset securitization products
Asset securitization products refer to the trust beneficiary rights shares issued by a special purpose trust (SPV) trustee institution on behalf of the special purpose trust (SPV).
In China, asset securitization mainly refers to credit asset securitization. Credit asset securitization refers to the process where banking financial institutions, as the originators, entrust credit assets to a trustee institution, which then issues beneficiary securities to investment institutions in the form of asset-backed securities. This is a structured financing activity where the cash generated by the property is used to pay the returns of the asset-backed securities. The types of credit asset securitization that commercial banks or other financial institutions have carried out include: corporate loans, commercial real estate mortgages, personal mortgage housing loans, small and medium-sized enterprise mortgages, auto consumer loans, and non-performing loans (NPLs).
Differences between stocks and bonds:
1. Distinction
Bonds are a type of investment similar to stocks. Unlike stocks, which represent a small part of a company with essentially no limit on its value, bonds typically represent a loan to a company or government. Bondholders usually receive predetermined payments (unless the coupon rate is floating) and a known maturity value. On the other hand, the returns for stockholders are less certain, and the price can fluctuate significantly based on the company's financial condition.
Risk and VolatilityStocks typically carry greater risk and volatility than bonds, which makes sense because bonds often have predetermined returns, while ownership in a company has significant potential for both upward movement and downward risk. As long as the market is open, stock investors actively price the potential for stock appreciation or the risk of decline, which can lead to considerable volatility, especially when expectations change. It is also important to know that in the event of a company's bankruptcy, debt holders have priority claim and will be paid before equity holders.
2. Coupon Payments vs. Dividends
Most bonds make coupon payments semi-annually, although they can be paid annually, quarterly, or even monthly. On the other hand, stocks can pay dividends, and these are typically paid quarterly, although not all stocks offer dividends.
3. The Life Cycle of Stocks and Bonds
When a bond reaches its maturity, the issuer repays the principal to the bondholders. However, unless a company repurchases its stock or is subject to an acquisition offer, stocks are generally traded indefinitely.