There is one principle in investment markets that holds true for most asset types, but particularly when it comes to bonds. The riskier the investment, the more you should be paid for it. The less risky, the less that asset is going to pay you. Bonds thrive off this principle.
Bonds are less well understood by investors than shares. They are far more complicated - and come in many more forms. There are incredibly secure and simple bonds and there are highly complicated and extremely risky ones. There are bonds that start off as bonds and then convert into shares. There are hybrids and collateralised debt instruments.
In the end, they are all about buying debt - which means the capacity for that asset to repay. The asset could be a company, a government, a municipality or even - as famously seen in the global financial crisis - a set of mortgages, collateralised into a bond.
Although shares are often ranked in terms of risk by share pundits, they don't actually come with a credit rating - that is, with the risk-ranking already attached. Bonds do. A bond regarded as AAA is deemed to be virtually impregnable - most government bonds are ranked to this degree, as well as the most solid of company debt. The flip side of this is that the high security of the investment means they tend to pay only sparingly. To make money from bonds, investors may have to look at bond issues of lesser worth - a B-grade bond all the way down to CCC.
Where do you start?
When you invest in a bond, you are lending money to a government or a company at an agreed interest rate for a certain amount of time. It is a simple "IOU". In return, the borrower promises to pay you interest at regular intervals and repay your loan at the end of the term.
People invest in bonds for this certainty of income and the fact that the values move with far less volatility than shares. It is unlikely you will ever hear (except during the global financial crisis) about a collapse in the bond markets. Financial advisers like to have them in their clients' portfolios for diversification purposes. They pay out at a secure, predetermined interest rate and their prices tend to move at a much slower rate - and degree - than shares.
Typically, bonds pay interest semi-annually, which means they can provide a predictable income stream. Many people invest in bonds for that expected interest income and also to preserve their capital investment.
High-quality government bonds - in particular, the so-called "risk- free" treasuries issued by the governments - were possibly the best of all investments during the financial crisis three years ago. While stocks were losing more than half their value, 10-year US Treasuries returned more than 10 per cent returns between May 2008 and March 2009. It was no surprise, then, that investors shelled out US$240 billion (Dh881.6bn) into bond funds in 2009, about 20 times the amount they put into share funds.
"The point people forget about bonds is that if shares are falling, corporate bonds won't fall by anything like as much," says Brad Newcombe, a director of FIIG Securities in Australia. "Assuming an issuer doesn't go broke - and it's unlikely to happen to bonds issued by governments or an IBM or Coca-Cola - the investor knows that he will always get the face value of the bond back."
A high-quality bond is a fairly simple animal. If an investor decides to invest $5,000 in a 10-year Government of Canada bond at 4 per cent interest per year - and hold it until it matures - he would get back the entire investment plus 4 per cent, or $200 a year. That's $2,000 over 10 years. If he had reinvested the 4 per cent interest each year, he'd have accrued almost $500 more.
Bonds, however, do react strangely to events. Interest and bond prices carry an inverse relationship; as interest rates fall, the price of bonds trading in the marketplace generally rises and vice versa.
If interest rates rose by 2 per cent over a 10-year period, the value of a bond would fall. It would be deemed a low income-producing asset. The investor would not lose money - the bond has to pay back the $5,000 and accrued interest as originally stipulated - but the return would be weak relative to the market. He would be onto a dud and may think of selling.
New bond issues would be offering higher rates with the same certainty of getting the money back.
If another investor bought the same 10-year bond one day at 4 per cent and the next day the market interest rates halved to 2 per cent, the income from that bond would then be twice as valuable and the price of the bond would rise accordingly. He would be onto a winner.
While timing and pricing are critical, there are other factors to consider when buying a bond. You need to know where a bondholder ranks in the event of corporate collapse. Are they secured or unsecured? Do they offer a fixed rate or a floating rate? When does it mature? Does the term of the bond suit your financial needs? Will the interest payments meet your income requirements? Are they worth the price the market is offering? Then there is inflation. If you have a bond earning 5 per cent per year and inflation is running at 6 per cent, you're losing money. It may be worth looking at inflation-protected securities.
The biggest question is this. Why does a company/municipality/government need your cash and why will it pay over the odds to get it? When it comes to companies, what sort of history has it had repaying debt? How much debt does the company have to begin with? How good is its cash flow to cover the interest payments to bondholders? Has the company ever defaulted on any current or previous debt or breached any conditions of its loans? If a company has a low credit rating, it may be trying to lure investors with a rate far in excess of, say, a bank term deposit or the dividends offered by major companies. Many have been conned by dodgy bonds.
This is when you have to do the homework. It may be that a company is strong, but has a severe short-term cash-flow problem. To stem this crisis, it offers a short-term bond at extremely attractive rates. If the investor deems this to be a good bet over the period of the bond, he might risk his money.
On the other hand, a company rated C to CCC is genuinely regarded as a junk bond. That is, they will pay you well, but there is always a risk of default - that they cannot repay at the rates they advertise. The best scenario here is that the bond has been mispriced, that it has been assigned a lower credit rating that it deserves. As it repays regularly, the bond then moves up the rank to say, BBB, which will strengthen the price of the bond, bring in more investors and, at the same time, keep the initial high interest rates offered.
The downside for most bonds is not default, but a couple of bad quarters or a punishing one-time event that will prompt rating agencies to reconsider the creditworthiness of a borrower. Should an issuer suffer a ratings downgrade, the price of its bonds will take a significant hit.
This is not just the case with company-issued bonds. Look, for instance, at the rates being offered on Italian government bonds while the country has been undergoing a debt crisis. Just like the corporate bond, it was recently offering a 10-year rate at 6.67 per cent, a rate many believe is close to unsustainable.
And here is the risk. Many think Italian government bonds are toxic. The bond price will only recover if - just like any company - the country puts in austerity measures and slashes its costs. Italy needs to cut down its pile of debt of €1.9 trillion (Dh9.2tn). The question, once again, is whether Italy's capacity to repay is a good long-term bet. If the investor believes the country will get out of debt, he will take the bond at this high rate, lock the high interest rate in and enjoy a rising bond price. But if the country defaults, he will have lost all his money.
Bonds are not easy instruments to determine. They are not like shares with a clear value, but are rated in terms of their ability to repay debt. There are a host of different kinds of bonds, with different maturities, rates and conditions. Many who feel the due diligence required is too much may prefer to invest in a bond fund instead. You will pay a premium for the management, but a well-run bond fund will have done all the bond rankings itself and should offer reasonable income. It should contain a very good spread of bond types and maturities from a range of issuers.
There is always the go-it-alone option for the intrepid. "A self-directed investor who takes the time to do his homework can do very well in this market," says one financial adviser. "Do it right and you can bump up the returns accordingly."