Bonds are a suitable tool for a novice investor. We talk about the types of bonds, how to evaluate their income on them, what are their advantages, and what risks you need to remember.
What are bonds?
Bonds are actually IOUs. They are issued by an issuer – a company that needs money, or the state – they can also be an issuer.
People buy bonds and thus lend their money to that company or government, expecting to receive a certain income. The full amount, terms, and amount of payments of this income (if several payments are planned), as a rule, are known at the time of purchase. The ability to estimate your benefit in advance is what distinguishes a bond from other securities.
The bonds are redeemed at the due date, that is, the issuer pays their owners the face value. There are also perpetual bonds – the issuer undertakes to regularly pay income on them, but may never repay them. At the same time, he usually has the right to redeem them at face value on certain dates – for example, once every five or ten years.
In addition to government and corporate bonds, there are also investment and structural bonds. They are issued by financial institutions, and they invest investors’ money not in their development, but in other stock instruments. These are complex products—buyers must evaluate the prospects not of a particular company, but of an entire investment strategy.
Investment and structured bonds are considered complex instruments because their returns are almost unpredictable. And in some cases, when they are redeemed, the owners receive even less face value.
But the main risk for the investor is the bankruptcy of the issuing company. In this case, he may lose all invested money: unlike deposits, they are not protected by the deposit insurance system.
What are the types of bonds?
Bonds differ in several ways.
- State -issued by countries or individual regions to cover the budget deficit.
- Municipal – issued by local governments, as a rule, to finance various projects.
- Corporate – issue companies to raise money for their development.
- Investment and structural – issued by banks, brokers, and management companies to invest investors’ money in other securities and receive a commission for this.
Private companies can also place a special type of bonds – commercial, which are distributed by address and by closed subscription. But it is impossible to just come to the exchange and buy them.
According to the form of payment of income:
- Interest-bearing (coupon) bonds – on them you will receive interest on the face value. Some bonds have only one payment, others have multiple payments.
The payment of interest is called coupon redemption. This name has been preserved since the days when bonds were paper: coupons for payments were attached to them, which were torn off at the time of redemption.
Most often, bonds have a constant coupon – the interest rate does not change during the entire life of the bond. A fixed rate is also common when each payment period has its coupon interest, but it is known in advance.
Variable Coupon occurs in long-term bonds – the rate is fixed up to a certain point, and then the issuer has the right to set another one, based on market conditions. Floating-rate
bonds have the most unpredictable income among coupon papers – interest on them is tied to macroeconomic indicators, such as inflation or the key rate of the Bank.
- Discount bonds – when purchased, they cost less than face value but redeem at face value. For example, you bought a bond at a discount – for 800 rubles, and when it expired, you received 1,000 rubles for it – the entire face value. The difference between the placement price and the face value is called the discount.
- Bonds with an indexed par value – they can have a constant coupon, say 2.5% of the face value, but at the same time, the face value itself changes regularly, for example, by the amount of inflation. Now several issues of government bonds are traded on the stock exchange with exactly this denomination, which depends on the rate of price growth in the country.
- Bonds with structured income (investment) – the income on them is not fixed and not guaranteed. It is only known in advance under what conditions what payment you will receive. For example, if the price of oil or a stock index falls within a predetermined range for a certain time, then the coupon yield will be 20%. If it exceeds this indicator, then 10%, if it turns out to be lower, the coupon will not be paid. The face value of the bond upon redemption will be returned to you in any situation in the financial market.
- Structural bonds – the terms of payments on them, as a rule, are even more complex than on bonds with a structured income. And in certain cases, you will receive even less money than you spent on buying this security. For example, the shares of four American companies can be taken as indicators on which payments depend. If the prices of all four increase by more than 10% during the life of the bond, then the coupon will be 20%. All will rise in price, but for at least one less than 10% – you will be paid 12%. One will fall in price, and the rest will not – you will not receive income, but upon redemption, you will be paid the face value in full. If at least two drops in price, only 80% of the face value will be returned to you.
- Short-term – maturity of less than a year.
- Medium-term – from 1 year to 5 years.
- Long-term – more than 5 years.
- Perpetual or perpetual – no maturity date.
By issue currency:
- Currency – they are also called Eurobonds, even if their prices are in dollars or yuan.
- Convertible bonds – they can be exchanged for other securities of the same issuer, such as shares.
- Non- convertible bonds – they cannot be exchanged for other securities.
- Secured – the most reliable. Their owner is likely to keep his money. The safety of investments can be ensured, for example, by collateral – real estate and equipment of the company, other securities. That is, in the event of bankruptcy of the issuer, the owner of the bond will be able to receive this pledge – sell it and return his money. The second collateral option is the guarantee of another company. If the issuer goes bankrupt, this company will assume obligations under its bonds. The third option is a bank, state, or municipal guarantee. This is almost the same as a surety. In this case, debts on bonds will be taken over by the bank, local or federal budget.
- Unsecured – less reliable. If the company goes bankrupt, bondholders will wait until the bankruptcy procedure is completed and their claims are satisfied in a general manner – along with other creditors of the company. Not the fact that it will be possible to return the invested money in full.
- Subordinated unsecured bonds are the riskiest. If the issuer of such bonds goes bankrupt, the investor will be able to count on the return of his money only as a last resort, after all, other creditors. And after the distribution of other debts, there is rarely anything left. In cases where subordinated unsecured bonds are issued by a bank, and due to financial problems, the regulator sends it for reorganization, the debt on these securities is simply written off from the bank’s balance sheet. Their owners cannot get their money back.
By way of contact:
- Floatable bonds – there are no restrictions on buying and selling such bonds. They can freely change owners: move from one investor to another.
- Restricted bonds – the purchase and sale of such bonds are restricted. For example, the owner cannot sell bonds for some time. Or the issuer sets limits on the price of bonds – when selling, it cannot be more or less than some limit. Or bonds are only for qualified investors – if you do not have the status of “qual”, you will not be able to buy them.
What bonds are available to novice investors?
Newcomers to the exchange can freely trade fixed-income government bonds of the Russian Federation (OFZ) or invest in corporate bonds with the highest credit rating – “AAA”.
To buy bonds from Russian and foreign issuers with a low credit rating, as well as structured bonds or bonds with a structured income, you need to pass a special test. Tests will show if you understand the features and risks of these tools. And they will also help you decide for yourself whether you are ready to invest in them.
Separate tests are provided for each type of risky bond. With one broker or management company, it is enough to go through the check only once – before making the first transaction. If you want to contact another intermediary, you will have to answer the questions again.
Testing will test the level of your knowledge about the tool. For example, you need to choose the correct definition of a credit rating, answer how quickly an investor can sell low-liquid bonds, or calculate the number of payments on a structured bond.
It should be borne in mind that some bonds, such as subordinated and most structured bonds, are intended exclusively for qualified investors – if you do not have such a status, you will not be able to buy them even after testing.
What taxes does a bondholder pay?
Income tax will have to be paid on coupon income (it is automatically calculated and retained by the issuer or depository) and on income from the sale of bonds (it is retained by the broker if the transaction was carried out through him).
Personal income tax from the coupon income will always have to be deducted. And from the income from the sale, it is not necessary under three conditions: if you bought bonds on the stock exchange, held them for more than three years, and earned less than 3 million rubles per year due to the price difference.
In the case when you invested money in bonds through an individual investment account ( IIA ), you can get a tax deduction.
What risks can a bondholder face?
Investing is always a risk. When buying bonds, for example, you should consider:
- Default risk is the risk that the issuer will go bankrupt and be unable to meet its financial obligations to the investor. If you have purchased secured bonds, this risk is low. You are very likely to be able to return the money thanks to a pledge, guarantee, or surety.
- Liabilities restructuring risk — the risk that the issuer will change the maturity of bonds, the amount of coupon income, and the timing and frequency of payments. The company may offer new terms to investors if it finds itself unable to fulfill the original promises.
- Liquidity risk is the risk that you will not be able to quickly sell your bonds at a fair price if you choose to do so before maturity. There will be few or no people willing to buy your papers. Often this happens when the issuer has financial problems or is just an unknown company. It is also usually difficult to find a buyer for structured bonds and bonds with structured income.
- Interest rate risk is the risk that average market rates on similar bonds will become higher. If your bonds have a fixed interest rate and it turns out to be below the market rate, then you are a loser – your income could be higher if you invested in other securities.
This risk is closely related to the movement of the key rate of the Bank of Russia, on which other rates in the financial market also depend. When the key rate falls, the interest rate risk does not materialize. But when it rises, the yield of new bonds usually rises and the interest rate risk for holders of old bonds increases.
- Inflation risk is the risk that inflation will accelerate and outpace a bond’s yield. It turns out that you will not increase yournaturall capital, but will lose part of it. After all, tomorrow you can buy less for it than today.
Investors should always be prepared to lose money, but for structured bonds, the risk of loss can be singled out separately. After all, it is known in advance that, under certain conditions, at the time of repayment, you will be paid an amount below par.
How to minimize all risks?
It is worth remembering that the minimum risks, as a rule, mean the minimum profitability. This is market law.
The most reliable can be considered government bonds, for example, federal loan bonds (OFZ), whichthe Ministry of Finance issuese. Their profitability is low, although still higher than inflation.
The next most reliable can be considered bonds of the largest companies with a high credit rating, such as “AAA”, and a moderate yield.
You can take a risk and invest some of your money in more profitable securities with an average rating – at the level of “B”. But in this case, be sure to take into account the risks of default, debt restructuring, and liquidity.
Before buying bonds, it is important to check how the issuing company is doing. Look at the news and study open financial and accounting reports – this data is available on the websites of the exchange and authorized news agencies. It is advisable to monitor the state of the issuer after the purchase of securities.
Read the rules for issuing bonds carefully. Find out how often the money will be paid out and through which organizations, where all important information about securities will be published. Specify whether the issuer has the right to early redeem or redeem the bonds and whether the owners of the securities themselves can demand to do this.
Pros and cons of bonds
- The yield on government, municipal and corporate bonds is on average higher than on a bank deposit, and it is usually set in advance. Or the rules by which it can be calculated are known.
- There are risks when buying fixed-income bonds, but they are less than when investing in stocks and other securities.
- The value of highly rated bonds do not fluctuate as much as the price of other securities. Most often, they are easy to sell at a price close to face value.
- If you invest in bonds through IIS, you can also get a tax deduction.
- Investments in bonds do not participate in the deposit insurance system, like other investments in the stock market. In case of bankruptcy of the issuer, you can lose everything.
- The yield of reliable bonds is low compared to more risky financial market instruments.
- In the case of investment and structural bonds, the risk of not receiving income or even incurring losses is very high. It is difficult to evaluate it even for experienced investors.
The most reliable bonds are available to everyone without testing – a suitable option for a novice investor. They allow you to save money and get a moderate income with relatively low risks.
The probability of losses when investing in other bonds is higher, although the profit may be greater. Therefore, before buying, you will have to study their risks and features, and undergo testing.
It is important to remember that any investment can result in losses. If you trade on the exchange through a broker, it is you who make the final decision to buy or sell bonds and are responsible for it.
To reduce the risk of losses, it is worth diversifying investments – that is, investing money in securities of different companies from different industries.