Bond Investing Guide 1: What are Bonds?

You have already learned the basics of stock trading and investing in our Stocks Tutorial and Guide. This
time, let’s learn another financial instrument: Bonds.

What are BONDS?

In very simple terms, a bond is an obligation by the borrower (bond issuer) to pay the lender (bondholder) a
specific amount of money at specified times in the future.

Like stocks, bonds are issued as a way of raising funds. If a company, for example, needs money to expand
the business or to pay out loans, they can choose to use stocks or bonds to raise capital.

Stocks vs. Bonds?

A major difference between a stock and a bond is that stocks do not guarantee any future payment (dividend)
while bonds have a known and specific payment in the future (coupon interest).

This means if you invest in stocks, you are not sure if you can earn by receiving dividends. Companies, even
if they are profitable, are not obligated to pay dividends to their shareholders.

Bond issuers, on the other hand, are required to announce a specified coupon interest rate prior to the issue.
This guarantees that bondholders will know how much they can earn in the future. If the bond issuer
suddenly becomes unable to pay its interest obligations, it is said to be in default.

Bond Terms: FACE VALUE, MATURITY DATE, COUPON RATE

The face value of the bond is the amount of money the bond issuer borrowed and must be repaid at the end
of the loan period. The face value is also called par value or principal.

The end of the loan period is called the maturity date. At the maturity date, the bond issuer is required to
pay the total amount of the loan borrowed from bondholders.

The amount of money earned from a bond is determined by the coupon rate or interest rate of that bond.
This is always announced prior to the issue. Most bonds pay semiannual (every 6 months) coupon interest,
although there are some that pay quarterly or annually.

How exactly an investor earns from bond investing will be discussed in Part 2 of our series on How to Invest
in Bonds.

Bond Investing Guide 2: How to make money with Bonds

This is the continuation of our series on How to Invest in Bonds.

In Bond Investing Guide 1: What are Bonds? you learned what bonds are, how they differ from stocks, and
some jargons associated with bond investing.

Here in Part 2, you will learn how to earn from bonds.

There are two ways to make money from bonds: through coupon interest and bond trading. In this article, we
will only focus on the first method — coupon interest — and we will defer the discussion of the second
method in a later article.

What is Coupon Interest Payment?

The coupon rate is the interest rate the bond pays. This rate is usually fixed for the duration of the life of the
bond, although some bonds pay a floating rate, meaning the interest rate is adjusted based on a benchmark
rate.

The rate is always quoted in percent, and the interest payment is simply the coupon rate multiplied by the par
value of the bond.

How to compute the Interest Payment

Let’s use as example a bond paying a coupon rate of 8% annually with a par value of P100,000.

The interest payment can be computed by multiplying the coupon rate of 8% with the P100,000 par value of
the bond.

8% x P100,000 = P8,000

Since the bond pays annually, it will pay bondholders P8,000 interest every year until the maturity date.

Annual- vs. Semiannual- vs. Quarterly-Paying Bond

If, for example, the same bond pays semiannually rather than annually, it will pay interest twice every year
(every 6 months). The annual interest payment of P8,000 will simply be divided into two payments, which
means the bond investor will get P4,000 every 6 months.

On the other hand, if the bond pays quarterly, the P8,000 annual interest will be divided into four interest
payments (to be paid every 3 months). Thus, an investor will receive four payments of P2,000 payable every
3 months.

Pros and Cons of receiving Interest early

In all of those scenarios, the investor will receive a total of P8,000 interest at the end of every year. In the
case of semiannual- or quarterly-paying bond, however, the investor receives part of the interest earlier
compared to a bond that pays annually. The investor thus benefits from the time value of money because he
or she already gets hold of the money rather than waiting for the end of the year to receive the cash.

The risk, on the other hand, is that if the investor wants to reinvest the coupon payment received but interest
rates have fallen, the funds can only be reinvested at a lower rate as opposed to the higher rate offered by the
original bond. This risk of reinvesting these funds at a lower rate is called reinvestment risk.

Reinvestment risk and other risks associated with bond investing will be discussed in Part 3 of our series on
How to Invest in Bonds.
Bond Investing Guide 3: Risks in Bond investing

This is now Part 3 of our series on How to Invest in Bonds.

In Part 1, you learned what bonds are while in Part 2, you learned how you can make money with bonds. In
this article, you will understand the different types of risks associated with bond investing.

Like any other financial instrument, a bond also has risks. Compared to other investment classes such as
stocks or real estate, however, the risk in bonds is generally lower.

Here are the specific types of risks in bond investing.

Reinvestment Risk

Reinvestment risk is the risk that the bondholder will reinvest the cash flows received from a bond at lower
interest rates. This usually happens when coupon interest payments have been received or when a bond is
called or when it is prepaid and interest rates have declined in the economy causing the bondholder to lose
out on the higher interest rate of the original bond.

Call Risk

A specific type of reinvestment risk is call risk, or the risk that the bond issuer will call the bond causing the
bondholder to reinvest the payment received at lower rates . Some bonds are callable, meaning, the issuer of
a bond has the option to “pre-terminate” the bond prior to maturity date. This usually happens when interest
rates have fallen. Since the issuer can simply make a new bond issue at lower interest rates, it will benefit
greatly by “calling” or “pre-terminating” the bond. When this happens, the bondholder receives payment but
is now at risk to reinvest the received funds in bonds that pay lower interest rates.

Prepayment Risk

Another specific example of reinvestment risk is prepayment risk, wherein the bond issuer returns the
principal at an early, unscheduled date to take advantage of declining interest rates in the economy. When
this happens, the bondholder is at risk to reinvest the returned principal in other bonds that pay lower interest
rates.

Inflation Risk

Most bonds pay regular coupon payments, in most cases, annually or semiannually. Bondholders may lose
on the “value of money” if the inflation rate in the economy is rising. For example, if the inflation rate in the
Philippines rose to 10% from 2008 to 2009, a product being sold for P1,000 in 2008 will now cost P1,100 in
2009. A bondholder receiving P1,000 coupon interest annually won’t have the same purchasing power in
2009 compared to 2008. This risk that the increasing prices caused by a higher inflation rate will decrease the
amount of real goods and services that bond payments will be able to purchase is called inflation risk.

Exchange Rate Risk

Exchange rate risk emerges when a bond makes payments in a foreign currency. For a Filipino investor
who purchases a bond that pays coupon interest in US Dollar, a depreciation of the Dollar versus the
Philippine Peso will reduce the returns to the peso-based investor. For example, if the dollar depreciates from
an exchange rate of US$1.00 = Php50.00 to US$1.00 = Php48.00, a peso-based investor receiving coupon
interest of $100 annually will receive less money after converting the dollar interest to peso.
Downgrade Risk

Bonds with high credit rating are generally considered low-risk. If they are “downgraded” to a lower credit
rating, they are assumed to be riskier than before. Investors of a downgraded bond will be faced with a
higher risk of default and lower price of the bond. This is downgrade risk.

Sovereign Risk

Bonds issued by a sovereign entity (more specifically, a country) are almost always low-risk. That’s because
they can always raise taxes or print more money just to be able to pay its bond obligations. If, however, the
country’s attitude towards repayment changes or its ability to repay worsens, the government bond becomes
riskier. This risk is called sovereign risk.

Event Risk

Any risk outside the risks of financial markets which can have a sudden and substantial financial impact on
the bond issuer’s financial condition is called event risk. For example, new regulations on clean air
requirements, storms that destroyed warehouses, or multi-million dollar theft by the CEO may cause
companies to incur losses which can reduce the cash available for bondolders.

After learning the risks of bond investing, you’re almost ready to make your first bond investment.

Up next: Types of Bond Investments and How to Invest in Bonds in the Philippines