A Bond is a debt investment in which an investor loans money to an entity that borrows the funds for a defined period of time at an interest rate paid at predefined intervals.
Overview of Bonds
Offering an alternative in times of unpredictable or stagnant equity and currency markets, Bonds can often be an important and conservative capital preservation component of an investment portfolio.
There are various types of Bonds but for the purpose of this guide we will only concentrate on two types of Bonds:
The Issuer is a Government which either issues Bonds in the domestic currency and/or issues Bonds in foreign currency, often EUR or USD. The domestic issues may be traded on an exchange whereas the issues in foreign currency are more often than not traded Over The Counter (OTC).
The Issuer is a Corporation (e.g. Apple Inc., Gazprom, Deutsche Bank) which needs to borrow money to expand its business. Corporate bonds are usually listed on major exchanges and the coupon (interest rate) is typically taxable. Corporate Bonds are OTC traded and are predominantly issued in EUR and USD.
Corporate bonds are usually considered higher risk than government bonds. As a result, interest rates are typically higher.
Basic definitions to understand when trading Bonds
The entity that borrows the money, by issuing a Bond. Issuers are typically governments (e.g. Germany, Brazil, Russia), municipalities (e.g. City of Buenos Aires), corporations (e.g. Gazprom, Volkswagen, Petrobras) and banks (e.g. Deutsche Bank, Citi Bank).
Investor (Bond buyer)
The person buying the Bond at a certain price, e.g. 90.00. The Investor receives the Coupon, e.g. 5% and expects the Bond to be paid back in full at Maturity at a price of 100.00. In this case the Investor expects to receive a higher return than the Coupon as the Bond is bought at a lower price than it is Repaid at – this higher return is expressed as the Yield(to Maturity.
Principal (Issue size)
Bonds are typically issued with a minimum Principal amount of EUR or of USD 250 million. A typical issuance is between EUR 250 and 750 million, with very large Corporations issuing Bonds with a Principal amount up to EUR 2 billion.
Yield (to Maturity)
The Yield describes the amount in cash (in percent terms) that returns to the Investor if the Bond is held to Maturity.
The date the Bond expires - the Principal shall be paid back in full (final instalment and interest payment).
Most common are either Fixed or Floating. A Bond with a Fixed Coupon pays the same interest throughout its life, e.g. 5.5 %, whilst a bond with a Floating Coupon is typically paying a fixed interest rate spread to an interest rate fixing and thus the Coupon is set at a predefined intervals. (Example: 3 months Libor +1.5 %.)
The Principal is paid back at the Maturity date - one Instalment.
Bonds are either traded via an Exchange or OTC (Over The Counter).
Repayment (Instalment) of the Bond
There are numerous ways the Principal can be paid back from the Issuer to the Investor. The most commonly issued type of Bond, approximately representing 90% of all issued Bonds, is the Bullet Loan type. A typical Bullet Loan cash flow profile is shown in the graph below.
Trade size / Lot size / Denomination
This is defined by two parameters:
- Minimum Lot size: the minimum nominal amount that can be traded. Most OTC traded Bonds have a Minimum Lot size of EUR 50,000 or higher.
- Lot Size: the incremental nominal amount that can be traded.
Bonds are quoted at a price. The price is usually quoted as the price for nominal value of 100. If a Bond is quoted at price = 105.00, it means that for each nominal value of 100 you pay 105. Using the example above where a Bond has a Minimum Lot Size of EUR 100,000 and the price is 105, then you must pay EUR 105,000.00 (100,000 * 105/100).
As any other financial product, Bonds are usually traded at a price spread. The price spread expresses the difference between the bid (the price you can sell at) and the offer (the price you can buy at). In the example shown above, you could buy at 105.00 (offer), so the price you can sell at (the bid) would usually be lower, for example 103.75.
The bid-offer spread on a Bond is dependant upon several parameters, the most common being the Rating of the Bond, the type of the Bond and the market liquidity (the ability to convert the Bond to cash quickly).
Corporate Bond issuers may have elected to have an official Rating of their Bond issuance. The Rating expresses a valuation of the credit worthiness of the issuer. There are three major Credit Rating Agencies which provide the service of rating issuers:
Standard & Poor's -
Fitch Ratings -
There are other types of Bonds that will not be dealt with as this is only a brief introduction. In the following we will concentrate on OTC traded Bonds.