Investing in bonds

 

What is a bond?

Companies and governments issue bonds to raise money for activities and investments. With a bond, you therefore lend money to a company (corporate bonds) or a government (government bonds). A bond is a type of debt instrument and makes you a creditor of the issuer. This is different to a share, where you contribute to the capital and therefore also have voting rights. Like shares, the price of a bond fluctuates daily and you can sell a bond at any time at the current market price. At the end of its term (the maturity date), you will normally receive back the principal (nominal value). However, if the issuer goes bankrupt, you may not be repaid, or will only be repaid in part.

Characteristics of a bond

A bond usually applies for a predefined period (the term). In exchange for your investment, you receive regular interest payments (usually annually) from the issuer, known as the coupon. The coupon is usually a fixed rate, although there are also institutions that issue bonds with a variable interest rate.

At the end of the term (on the maturity or redemption date), the issuer must redeem (repay) the total amount of the bond to all investors. In a normal situation, you will therefore receive your money back. With a bond, you do not become a co-owner and you do not have any voting rights, which is an important difference to shares. However, a bond can be traded and has a stock market price. You can therefore buy bonds after issue and sell them again before the maturity date.

Nominal value and denominations

The nominal value of a bond is the amount that the issuing institution wants to raise. This is also known as the principal. This is issued in equal parts, known as denominations. You can buy these denominations on the stock exchange, often in units of €1,000.

Example: for a loan intended to raise EUR 500 million, the issuing institution may issue the bond in 500,000 denominations of €1,000 each. In this way, the bond can easily be traded on the stock exchange and many different investors can invest in it.

Primary and secondary market:

On the primary market, the bond is issued for the first time by the company or government. Its value is called the nominal value. Note that for an issue, you rarely pay the nominal value. Instead, you pay the issue price. This may differ slightly from the nominal value, namely above par (bond is listed at above 100% of the nominal value) or below par (bond is listed at below 100% of the nominal value).

If the buyer who bought the government or corporate bond on the primary market sells the bond before its maturity, it will be on the secondary market. The price may differ from the original issue price and is determined by supply and demand.

 

Types of bonds

Government bonds

A government bond is issued by a government, usually to cover a budget deficit. Belgian government bonds are issued in euros. There are also US government bonds in dollars, German government bonds (in euros), and bonds from less-developed countries in their own currencies. The European Central Bank also issues bonds that have become known as Eurobonds.

Corporate bonds

Corporate bonds generally work the same way as government bonds. With a company, the risk that the company will be unable to repay the loan is often greater than it is with a government. However, this depends on their creditworthiness (you can read more about this below). This higher risk is reflected in a higher potential (coupon) rate.

Special bonds

Special bonds have special characteristics and conditions, while they also entail additional risks. Examples are subordinated and perpetual bonds. Special bonds fall within the category of complex investment products. You can read more about special bonds in the Investors' Academy under ‘Special bonds’.

Bond funds and ETFs

As an alternative to buying individual government bonds or corporate bonds, there are investment funds and ETFs that invest in several bonds at the same time. This means your investment is better diversified.

 

How creditworthy is the issuing party?

We have previously said that in a normal situation, you will get your money back. But what is a normal situation, and what isn't? This is all about the financial health (creditworthiness) of the issuing institution. If the issuing institution is financially sound, they will pay the interest every year and repay the principal on the redemption date.

However, the worse the issuing institution's creditworthiness, the higher the risk that it will be unable to pay the interest each year and unable to repay the principal on the redemption date.

Credit ratings are monitored

To determine whether an issuing institution is financially sound, there are special rating agencies that give the bonds a rating. Well-known rating agencies are Standard & Poor's, Moody's Investors Services and Fitch Ratings. They use letters and numbers to indicate an issuing institution's creditworthiness. AAA is the highest creditworthiness rating, while C is the lowest. With a D rating, the institution is already bankrupt.

What the ratings tell you:

  • The higher the creditworthiness, the greater your certainty of getting your money back.
  • The lower the creditworthiness, the greater (credit) risk you run of getting your money back. This higher risk is therefore usually offset by a higher coupon. Of course, you are only willing to take higher risks if you expect to be rewarded with a higher interest rate.

Investment grade and non-investment grade

  • The table below shows which codes the rating agencies use for creditworthy issuers (investment grade) and for non-creditworthy issuers (non-investment grade bonds or high-yield or junk bonds).
Investment grade en non-investment grade
 

Bond yields

The return on a bond is determined by a number of factors:

  • The coupon – the interest rate of the bond
  • The price of the bond
  • The remaining term to maturity and redemption

The coupon interest

The term coupon dates back to the time when bonds were still printed on paper. The coupon shows the interest rate, which is also known as the coupon rate. You receive the coupon interest regularly (usually annually) on a fixed date (the coupon date).

The price

The price indicates the value of a bond as a percentage of the original nominal value. This will not always have to be the amount you paid when you bought the bond (your investment). 

A bond with a principal of €1,000 and a price of 98% is therefore worth €980 at that time. Most bonds are redeemed on maturity at 100%. However, the percentage sign is often omitted when the price is displayed.

It's worth remembering that if the price is 100%, this is also called 'at par'. If the price is lower than 100%, however, this is called 'below par'. And if the price is higher than 100%, this is referred to as 'above par'.

The term

It goes without saying that a loan has to be repaid. The remaining time to redemption (repayment) is the term, while the date on which the redemption takes place is called the maturity date. A loan with a longer term to maturity is more risky than one with a short term to maturity. This is reflected in a higher coupon (interest rate).

How the returns evolve

Bond prices are constantly changing. This is partly due to changes in interest rates on the capital markets – the market interest rate. In general, the following applies:

  • If the market interest rate rises, the price of the bond will fall.
  • If the market interest rate falls, the price of the bond will rise.

How far prices move depends on the bond's remaining term to maturity:

  • The further into the future the redemption date of the bond lies, the more sensitive the price of the bond will be to a change in interest rates.
  • As the bond comes closer to the redemption date, the more the price will settle around 100%. In this later phase, market interest rates will have little impact on bond prices.

In addition, any changes in the issuing institution's creditworthiness plays a major role – especially if the creditworthiness deteriorates, as this could result in a sharp drop in prices. This is because it is becoming more uncertain whether the issuing institution will still be able to repay the principal.

 

The risks of bonds:

  • Liquidity risk:
    The liquidity of the bond, the ability to buy or sell a bond during its lifetime, is very variable. It depends mainly on the volume of the issue (the larger the issue, the more efficient the secondary market), the transaction volume and the type of issuer (government bonds can generally be traded more easily during their term than bonds issued by individual companies).

  • Price risk:
    This risk depends on the remaining term of the bond (the further away the bond is from maturity, the more sensitive the bond will be to interest rate fluctuations) and the issuer's current financial situation (bond prices react negatively to any deterioration in the issuer's rating and to the risk that it may deteriorate).

  • Exchange rate risk:
    You only need to deal with this risk if a corporate or government bond is denominated in a foreign currency. Currency exchange rates fluctuate every day. If the currency in which the bond is listed falls in value, you may receive back less than your original investment in your base currency. This risk is also present at the time of payment of each coupon.

  • Interest rate risk:
    This can result in a loss for the bondholder and is therefore greater in the event of a sale before maturity. The value of an issued bond falls when market interest rates rise. The longer the remaining term of the bond, the greater its sensitivity to interest rates.
 

Costs and taxes on bonds:

  • Tax on stock exchange transactions (TST):
    Tax applicable when buying and selling bonds on the secondary market.

  • Withholding tax on interest:
    In Belgium, withholding tax is charged on interest payments. Interest on bonds issued by foreign companies is charged first in the country of origin and then in Belgium. Some of this can be claimed back from countries with which Belgium has signed a double taxation treaty that includes provisions for its repayment.

  • Brokerage fee:
    The cost of executing your orders on the secondary market.

  • Custody fee:
    The fee for holding an instrument in a custody account.

  • Sales and placement commissions:
    When you buy a bond on the primary market, you pay a placement fee. Together with the nominal value, this constitutes the issue price.

  • Capital gains tax:
    If you sell bonds at a profit before maturity, you do not have to pay any tax on this. Note that you must pay withholding tax on the difference between the purchase price and the redemption of a zero-coupon bond.
For a recent overview of our standard costs and taxes, please consult our list of charges.

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