- What are the differences between bonds and stock
- Are bonds risky? – what are the risks?
- Understanding the wording – maturity date, coupon rate, etc..
- Different types of Government Bonds
- What are Corporate Bonds
- How are bonds taxed?
- How do I buy bonds?
Bonds are another investment vehicle that are traded on the stock market. The bond price can go up or down just like stock prices but the difference between bonds and stocks is that a bond will provide regular income until the maturity date. Once the maturity date has been reached then the holder of the bond will receive par value (original investment) of the bond.
Bonds are essentially loans to a government or corporation, the purchaser is lending their money to the entity with the expectation of receiving interest payments on a regular basis and receiving their money back at the end of the loan, also known as the maturity date. Bonds are classed as fixed income investments because they pay interest payments on the loan at regular intervals.
As an Irish tax payer, buying Irish Government bonds is a tax efficient investment approach because growth on these Government bonds are tax free. The bondholder will still have the pay tax on the income but they do not have to pay capital gains tax (CGT) on any growth of the bond.
Bonds can be purchased or sold on the secondary markets just like stock. If the price of the bond is above the par value (original value of the bond, usually €100), it is said to have a premium. If it is lower than par value then you will be buying at a discount.
There are still risks involved in buying bonds but they are classed as less risky than equity shares. Some of the risks are;
Credit Risk. This risk is based on whether the Government or Corporation can afford to pay back the loan. This is usually not an issue for Government as they can print their own money but a Corporation can go bankrupt and may not have enough assets to buy back the bonds.
Inflation Risk. The original value, also known as the par value of the bond is returned to the bondholder at maturity date but the money paid back will have declined in value in that period of time. The risk here is that it hasn’t declined more than the interest received. For example, let’s say the bondholder purchases a 10 year bond for €10,000 at 3%. The bondholder will receive the interest payments of €300 per year and at the end of the 10-year period, the bondholder will receive back their €10,000. However, if inflation skyrocketed in those 10 years to an average of 5% per year then essentially they would have lost 2% (5% inflation minus 3% interest) of their money each year.
Currency Risk. This only comes into effect if the bonds being purchased are in another currency. The risk is that the other currency decreases in value more than the bond is paying in interest. For example, if the bondholder buys a bond in Japanese Yen that has an interest of 3% but the Japanese Yen falls against the Euro by more than 3% per year.
Interest Rate Risk. This risk comes into effect when purchasing or selling the bond. The trading price of the bond will fluctuate based on the interest rate. A higher interest rate will decrease the trading value of the bond and a lower interest rate will increase the trading value of the bond. Notice that I said ‘trading value’ of the bond as the par value (original value) is not affected.
A few things to understand before you decide to purchase bonds.
Par Value. Is the amount the issuer has promised to repay to the bearer of the bond when it matures. The Pay Value may be different from the face values if a premium or discount is achieved. Similar to stock, bonds also increase and decrease in value depending on interest rates and how the economy is expected to perform.
When interest rates increase, bonds normally decrease in value. A bond with a face value of €1,000 may be able to be purchased for €975, in other words, you are purchasing the bond at the discount.
On the other hand, if interest rates decrease, bonds tend to increase in value. A bond with a face value of €1,000 may demand €1,075 in order to purchase it. This is known as a paying a premium.
Coupon. Is the interest that the bond will pay per year. A 5% coupon will pay 5% interest per year based on the par value of the bond. The interest payment stops on maturity of the bond. If the original value of the bond is set at €1,000 and the coupon rate is 5% then the holder of the bond will receive an income of €50 for every €1,000 bond that they hold.
Keep in mind that you may not always be able to purchase the bond at face value; you may pay a premium for it or you may be able to get it at a discount. If the purchaser paid a premium then they will still be receiving 5% of the par value but that would be less than 5% of what they paid for the bond. For example, if the par value is €1,000 and the purchaser paid €1,075, the yearly payment would still be €50. Which is 4.65% of the purchase price.
If the purchaser got the bond at a discount then the opposite is true, they would be getting a higher percentage than they paid for the bond.
Maturity Date. The bond has a limited time period when the loan needs to be paid back. Once the bond reaches its maturity date then the final interest payment is made and the par value of the bond is returned. After this date the interest will no longer be paid.
Governments issue bonds in order to raise money for big-ticket items such as infrastructure, building construction, or other in-demand needs. The money raised from the bonds are used for the stated reason and the interest is paid back on a yearly and sometimes half-yearly basis. Once the bond has matured the Government then buys back the bonds at par value and the debt is then paid in full.
Government bonds tend to be the most stable, lowest risk investment. Most Governments will not renege on a bond if at all possible as a country’s good credit worthiness is vital in order to have access to cheap credit.
Irish Government bonds must be bought through approved stockbrokers. See a list here, under the Primary Dealer System section.
There are two different types of Government bonds:
Amortized Bond. An amortized bond is one that pays down the principle and interest on a regular basis. This behaves as a true loan would where the principle + interest is getting paid down. As the principle of this type of bond gets paid before the bond matures, it is classed as a less risky bond.
Here are some examples of an amortized Irish bonds:
|Jul 20, 2027
|Mar 20, 2032
|Jan 20, 2037
|May 20, 2042
|Sep 20, 2047
Floating Rate Treasury Bond. A treasury bond that pays interest on a predetermined basis, usually yearly, and then returns the par value of the bond on maturity (see maturity date above). Treasury bonds usually mature 5, 10, or 20 years.
The floating rate means that the interest rate for the period is based on the Euribor interest rate. In other words, this is not a fixed income but one that increases and decreases in value based on the European interest rate.
There are currently two floating rate treasury bonds from the Irish Government.
|June 18, 2051
|June 18, 2053
Corporate bonds are more secure than buying stock in that same company as bond holders get paid before equity investors should the company get into financial trouble. When a company does get into financial trouble such as bankruptcy the assets of the company and cash are paid out in order of bonds, preferred shares, then common shares.
Corporate bonds, like Government bonds, pay out interest on a regular basis; usually yearly but can also be every six months.
Just like Government bonds, Corporate bonds will earn income each year to the bondholder until the bond matures. Once the bond matures, the bondholder will receive the par amount of the bond. Corporate bonds have different investment grades ranging from AAA to Junk bond. AAA is the most secure, then in order of credit worthiness they are ranked: AA, A, BBB, then junk.
Ensure that you understand the type of bond you are buying; a corporate bond can be downgraded to a lower rank very quickly. That would make it difficult to sell the bond or get your money back.
The income from Irish Government bonds will incur income tax, that could be either 20% or 40% depending on your marginal rate. There is no capital gains tax on Irish Government bonds for Irish tax payers.
How to Buy Bonds
Unfortunately, only registered stock brokers can buy or sell Irish Government bonds. This places bonds out of the reach of smaller investors as the registered stock brokers usually require large capital in order to start and account. On top of that, they usually charge large fees.
I have noticed that it is possible to purchase Government bonds from other countries (such as France, Germany, Netherlands) in Degiro. When you log into your account, go to Price > Bonds.