Bonds can be bought and sold in the secondary market after they are issued. While some bonds are traded publicly through the exchange, most trade over-the-counter between broker-dealers acting on their clients’ or their own behalf.
A bond’s yield is the actual annual return an investor can expect if the bond is held to maturity. Yield is therefore based on the purchase price of the bond as well as the coupon.
A bond’s price always moves in the opposite direction of its yield. The key to understanding this critical feature of the bond market is to recognise that a bond’s price reflects the value of the income that it provides through its regular coupon payments. When prevailing interest rates fall – older bonds of all types become more valuable because they were sold in a higher interest rate environment and have higher coupons. Investors holding older bonds can charge a “premium” to sell them in the secondary market. On the other hand, if interest rates rise, older bonds may become less valuable because their coupons are relatively low, and older bonds therefore trade at a “discount”. The inverse relationship between price and yield is crucial to understanding value in bonds.
The possibility that a bond issuer will be unable to make coupon or principal payments when they are due is known as the default risk. Credit rating agencies give credit ratings to bond issues, which helps to give an idea of how likely it is that a payment default will occur. Investors must consider the possibility of default and factor this risk into their investment decision. The bonds with the highest credit risk are high-yield bonds, issued by companies with low credit ratings. They pay higher interest, but there’s a higher risk the investor won’t receive any interest payments or get back his/her original investment. Credit ratings can change over time, so it’s a good idea to monitor the ratings of any bonds you own. If an issuer’s credit rating goes up, the price of its bonds will rise. If the credit rating goes down, it will drive its bond prices lower.
Market risk refers to the risk that the bond market as a whole would decline, bringing the value of individual securities down with it regardless of their fundamental characteristics. One often overlooked aspect of credit investing is the contract between the company and the investor which is the covenant. A covenant is defined as an agreement, usually formal, between two or more persons to do or not do something specified. The analysis of bond covenants should be part of the analytical process or framework as it makes investors aware of their contract with the issuer. Should there come a time when covenants are in the spotlight or the company is in danger of breaching them, investors who understand their contract will have the ability to act proactively in protection of their capital, principal or investment.
When a bond issuer fails to make an interest or principal payment by the due date, the bond issuer is generally considered to have defaulted and it means an “Event of Default” has occurred. Failure by the issuer to observe financial covenants, such as ensuring net borrowings to total equity do not exceed a certain ratio could also constitute an “Event of Default”. It should be highlighted that the issuer in times of crisis will ensure to the best of its ability not to trigger any of the “Events of Default” clause.
When an issuer defaults on its bond payments, there are three possible outcomes namely:-
- debt restructuring,
- winding up or
- judicial management.
Bond investors can choose from many different investment strategies, depending on the role or roles that bonds will play in their investment portfolios.
Passive investment strategies include buying and holding bonds until maturity and investing in bond funds or portfolios that track bond indexes. Passive approaches may suit investors seeking some of the traditional benefits of bonds, such as capital preservation, income and diversification, but they do not attempt to capitalize on the interest rate, credit or market environment.
Active investment strategies, by contrast, try to outperform bond indexes, often by buying and selling bonds to take advantage of price movements. They have the potential to provide many or all of the benefit of bonds; however, to outperform indexes successfully over the long term, active investing requires the ability to:
- form opinions on the economy, the direction of interest rates and/or the credit environment;
- trade bonds efficiently to express those views; and
- manage risk.