Types of Bonds and Their Risk Profiles
A bond is a type of loan where an investor lends a certain amount of money to the borrower by buying bonds from them.
The borrower (ranging from small businesses to corporate or governmental bodies) will issue bonds to finance projects or business obligations.
Investors receive interest (known as a ‘coupon’) on the money that they lend, until it is later paid back in full (known as ‘return of principal’).
Bond terms will set out when the loan is due to be paid back (the maturity date) and the terms of the interest payments (which can be variable or fixed).
There are several different kinds of bond, which vary in their focus and risks. The main types of bond are government bonds, corporate bonds, junk bonds and savings bonds.
How Are Bonds Rated?
These ratings aim to highlight the financial stability (or, perhaps, instability) of the bond in question. They attempt to determine the likelihood of the bond being repaid or the interest rates being met.
Bonds are typically rated on an alphabetical scale. High-grade bonds (those most likely to meet their obligations to the investor) receive the highest credit rating of AAA.
More speculative bonds (where it is not certain financial obligations will be met) receive ratings of C and below. These bonds are considered 'higher risk', as you may not receive back the money you invested or earn a substantial amount of interest.
How Are Bonds Priced?
Typically, bonds are priced at a nominal rate of £100 per bond in the UK and $1,000 in the US (the par value), though this number is highly likely to fluctuate once a bond hits the market.
A bond can potentially have a term of 30 to 50 years, and it is likely the bond price will change a lot over this time. Bond prices are less likely to fluctuate in bonds with a short duration.
When a bond comes to market, the asking price for the bond can be lowered (this is referred to as a 'discount') or even raised (referred to as a 'premium').
The prices of bonds fluctuate for a number of reasons:
- Supply and demand – When the stock market is booming, investors are likely to move their money from bonds into equities (and vice-versa).
- Credit rating – The credit rating of the company or institution issuing the bond will affect the bond price. If it has a poor credit rating, it will be considered higher risk and attract a lower price.
- Interest rate – If your bond is paying a fixed coupon rate that is above the current market rate of interest for investments, the bond will be attractive and, therefore, priced at a premium.
- The age of the bond – The price of a bond can stabilize to its par value when it draws closer to its expiration. This is because its true value will only be the same as its ‘return of principal’ amount, and interest rates are unlikely to change in shorter time frames.
Types of Bonds
Below is a list of different types of bonds and their respective 'safety'.
It is important to remember that bonds, in general, are considered by many to be a safer form of investment than equities.
Government bonds (known as 'Gilts' in the UK) are bond portfolios issued by government agencies or national treasuries to raise funds.
As governments tend to have good financial stability, it is likely that the conditions of the bond will be met (the money will be returned with interest). This means that government bonds are considered low risk.
Supranational bonds are similar to government bonds, though they tend to be taken out by banks (such as the World Bank or the European Investment Bank). Supranational bonds are also considered to be low risk.
There are various types of corporate bond; investment-grade corporate bonds are the most common.
'Investment grade' means that the bonds are taken out by a company with a high credit standing. They are therefore highly likely to meet the demands of the bond in regards to repayment.
In general, corporate bonds are considered to be a relatively safe fixed-income investment, and tend to have a higher interest rate (coupon threshold) than government bonds.
Junk bonds are another form of corporate bond, taken out by companies with a lower credit rating.
As a result, they are considered to be a much higher risk than investment-standard corporate or business bonds. Of course, investors will receive a greater amount of money if the risk pays off and the bond is repaid in full.
Junk bonds are often required by companies that are undergoing some kind of financial struggle – meaning that the likelihood of them being able to meet the demands of the bond is lowered.
Savings bonds are offered by banks and building societies. Their low pricing makes them popular with retail investors, especially those with little experience of investing.
Savings bonds are considered fairly low risk, but their value can fluctuate rapidly and the maturity terms are often lengthy.
Types of Securities Based on Bonds
One example of this is debt securities, which are based on government or corporate bonds.
Purchasing a debt security will typically allow an investor to enjoy the same benefits of a bond at a more reasonable price – meaning that they will still have the opportunity to receive interest at regular intervals throughout the year.
When the financial year ends, the investor has the opportunity to reinvest in the security, or they may choose to take their money elsewhere.
Securities also allow for 'bond mutual funds', which represent an efficient way to hold multiple types of bonds in one asset.
This allows for greater diversification (and hence reduced risk) and greater efficiency (for example, it allows you to buy multiple bonds of a given type, or a minimum credit rating).
Bond exchange-traded funds are similar to mutual funds; they differ in that an investor in bond exchange-traded funds does not actually own the bonds (while an investor in mutual funds will).
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