Bonds - another world for investment

The global bond market was valued at approximately $138.4 trillion at the end of 2023*, making it significantly larger than the global stock market, which had a total capitalization of around $115.1 trillion.

Approximately 20% more capital is invested in bonds than in equities worldwide, highlighting why professional investors closely monitor bonds.

Bonds are a Powerhouse

Bonds are not just another asset class. By definition, bonds set the borrowing costs for governments, companies, and consumers, and fundamentally shape central bank policy and economic cycles.

When you buy a bond, you are lending money to an entity. Such a loan has fixed interest payments and repayment of principal (the original amount of money you invest). For example, if you buy a bond with a face value of $1,000, this is your principal. When the bond matures, you expect to receive $1,000 unless there’s a default.

Bonds are not risk-free. If the borrower (the company, government, or other entity) defaults -meaning they can’t repay their debt - you could receive less than your original principal, or even nothing at all. Even if there’s no default, if you sell the bond before maturity, its market price may be lower than what you paid, resulting in a loss.

The bond market operates through both primary (new issuance) and secondary (trading) markets, and is dominated by large institutions.

The Basics for Investing in the Bond Market

There are some core terminologies you need to understand to ensure you make informed decisions:

• Principal (Face Value): The original amount you lend to the issuer, typically what you’ll get back at maturity.
• Coupon Rate: The annual interest rate paid by the bond, usually as a percentage of the principal.
• Maturity Date: The date when the bond’s principal is due to be repaid.
• Yield: The effective return you receive, factoring in the bond’s price and coupon (it can be current yield, yield to maturity, or yield to call).
• Current Yield: The annual interest payment divided considering the bond’s current market price. For instance, if you buy a bond for $950 and it pays $50 per year, your current yield is 5,26% ($50/$950).
• Yield to Maturity (YTM): Estimation of total annualized return if you hold the bond until it matures, factoring in both interest and any gain/loss from buying at a price different from face value.
• Yield to Call: Is very similar to YTM, but assumes the bond is redeemed early at the first call date instead of final maturity. Such a parameter is relevant for callable bonds, where you may get your money back sooner if the issuer decides.
• Credit Rating: A measure of the issuer’s ability to pay back debt, assigned by agencies like Moody’s or S&P.
• Issuer: The entity borrowing your money (government, corporation, municipality).
• Clean Price: The bond’s price, excluding accrued interest.
• Dirty Price: The price including accrued interest since the last coupon payment.
• Call Option: Some bonds allow the issuer to repay principal early, and such an option is very important for assessing reinvestment risk.
• Default Risk: The risk that the issuer cannot make payments as promised.

Bond-Buying Checklist: What to Watch Before You Tap "Buy"

Although all these concepts are important for understanding how the bond market works and what returns you can reasonably expect, there's a short list that can guide you through the decision-making process:

• Yield to Maturity (YTM): Calculate the true total annual return if you hold the bond to maturity, factoring in both coupon and price.
• Credit Risk: Always check the credit rating of the issuer to avoid lending money to an entity with a lower score.
• Maturity Date: For how much time are you willing to lock up funds? Longer maturities usually mean higher yields, but also represent a higher interest rate risk.
• Currency Exposure: Is the bond in euros, pounds, or dollars? Currency moves can impact your real return.
• Liquidity: Can you sell easily if needed, or are you likely to face a discount?
• Costs: What are the spreads and fees? Small differences here can erode returns.

Yields Matter

Current yield gives a snapshot of income now, but ignores what happens if the bond price differs from face value or if it’s sold early. YTM tells you the true total return if you hold to maturity, which is crucial for comparing bonds with different prices and maturities. Yield to call is essential if the bond can be called early: it often caps your upside, because you may have to reinvest at lower rates if the issuer calls the bond.

🧭 Example That Clarifies All

Bond face value: $1,000 | Coupon: $50/year | Price: $950, callable in 3 years at $1,000, and maturity in 5 years.

Current yield: $50 /$950 = 5,26%

YTM: Higher than 5,26%, because you gain $50 as the bond moves from $950 to $1,000 at maturity.

Yield to call: Calculated like YTM, but assumes you only receive interest and principal until the call date (3 years), not full maturity.

What Should Guide Your Choice?

A seasoned investor holds a varied portfolio that balances risk and reward according to their financial objectives, time horizon, and especially their risk aversion.

An investment portfolio is a collection of financial assets, like stocks, bonds, cash, or funds. There are 3 core allocation types:

1. Conservative Allocation: Focuses on capital preservation. Most assets are in low-risk investments such as bonds and cash equivalents. Stocks make up a small fraction. This suits investors highly averse to losses, even if it means lower returns.

2. Balanced (or Moderate) Allocation: Seeks a mix of growth and stability. Typically splits assets between stocks and bonds (for example, 60% stocks, 40% bonds). This portfolio accepts some volatility for better long-term growth, but limits risk compared to an all-equity approach.

3. Aggressive Allocation: Prioritizes high growth by investing mainly in equities (stocks) and sometimes alternative assets. Bonds and cash play a minor role. This approach only suits investors comfortable with higher volatility, who accept the potential risk of losses in exchange for higher long-term returns.

In August, we enter a kind of "silly season" for investors, as I previously explained in an article before going on vacation. Take time to rest, but also for revising and or planning your investment strategy.

This content is for informational purposes only and not investment advice.

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