Bonds are financial assets that can be bought and sold at any time. And they can be very complex. In this post we will discuss how you can analyze bonds. The goal is to confidently invest and understand fixed income markets.
- What is a Bond
- Example Bond to be used throughout this analysis
- Most Important Metrics to Analyze a Bond
What is a Bond
A bond is a debt security issued by a government or a company. The government or company that issues the bond (the issuer) agrees to pay us interest (known as coupon payments) and, on a certain date, pay back the money we have lent to it.
As you can see, a bond is very similar to a loan.
However, there is an important distinction between a bond and a loan: bonds are much easier to buy and sell. There is a very active market for them, making it convenient to trade them.
This means that, if we lend money to a company, we do not have to wait for that bond to mature to get our money back. We can simply sell the bond to another investor. But we must bear in mind that the bond prices fluctuate constantly.
As a result, it is essential to understand how to analyze a bond. That will allow us to understand why their prices move and help determine if they can be a good investment.
Example Bond to be used throughout this analysis
We will look at the following bond to analyze its most important metrics throughout this post:
It is a bond issued by Apple in US Dollars and with an annual coupon rate of 3.75%. The expiration date is February 9th 2045, about 22 years from now. The price of the bond is 84. Other characteristics that are of interest us are the following:
- Yield: 4.56%
- Risk premium (spread): 92 basis points (0.92%)
- Duration: 15 years
- Credit rating: AA+
Most Important Metrics to Analyze a Bond
These are only the most relevant characteristics of a bond. For those who want to learn all about bonds, I recommend the book Inside The Yield Book.
The Currency is a fundamental feature of a bond. In fact, the currency is much more important for a bond than for a stock. Why? Because a stock represents ownership in a real company. But a bond tells us exactly how much currency we are going to receive by holding it. So we better know in which currency a bond is denominated.
In the example used, the bond is denominated in US dollars (USD). That means we are going to collect our interest payments in dollars. And when the bond comes due in 2045, we will receive the principal back in dollars as well.
There are many different currencies in the world. Strong currencies tend to have low nominal interest rates, such as the Euro, the US Dollar or the Swiss franc. Weaker currencies are associated with higher interest rates but also higher inflation, losing value relatively fast.
The challenge is to find the ideal balance between the strength of a currency, the potential return it offers us and the speed at which it devalues.
The coupon tells us the amount of interest that we will receive on a regular basis. The coupon quoted is always on an annual basis, although payments can be made on an annual, semi-annual or quarterly basis.
For example, the Apple bond has a coupon of 3.75%, paid on a semi-annual basis. This means we get paid 1.875% interest every 6 months.
The coupon, or interest, is calculated based on the principal amount of the bond we own. If we have $100,000 of that Apple bond, we are going to get $3,750 in interest every year, in the form of two payments of $1,875.
The price of the bond is what we have to pay for it if we buy, or what we will receive for it if we sell. The price of a bond is quoted as a percentage. Consequently, it tends to trade close to 100. In fact, a price of 100 means that in order to buy $100,000 of notional value, we will pay exactly $100,000.
In the case of our Apple bond, the price is 84. That means that if we want to buy $100,000 of that bond, we will have to pay 84% of that amount, or $84,000.
When a bond trades above 100, it is said to trade above par. If the price is below 100, the bond trades below par.
Why is it that a bond trades above or below par? Many variables determine that. But the most important thing is how attractive the interest it pays is relative to the level of interest rates in the market and the riskiness of the issuer.
For our bond, the market believes that receiving an annual coupon of 3.75% for 22 years from Apple is only worth 84% of the notional amount.
In general, bond prices rise when interest rates fall, making high coupons become more attractive, or when the risk of that issuer decreases.
Prices fall when interest rates rise and investors are willing to pay less for bonds with low coupons, or when an issuer’s credit risk increases (for example, if Apple saw weak sales numbers for their new iPhone).
The yield tells us the annual return that we can expect from a bond if we buy it today (at the price it is trading), hold it until maturity, and there is no default.
As a result, the yield on a bond directly depends on the price at which it is quoted. When we hear that interest rates rise, bonds continue to pay the same coupons, but their yields are going up.
Why does the yield of a bond go up? When its price falls. If we pay less to buy a bond but will receive the same future cash flows, it makes sense to expect a higher return.
Our Apple bond has a yield of 4.56%. If we buy the bond today at a price of 84, hold it until maturity in 2045, and Apple does not go bankrupt during that period, the annualized return on buying that bond will have been 4.56%.
When the price of a bond is above 100, the yield is less than the coupon. If the price is below 100, the yield will be higher than the coupon.
In the yield calculation we also assume coupon payments will be reinvested at the same rate.
If a bond is trading at a negative yield, it means its price is so high that we will pay more for it today than all the cash flows we will receive from owning it. For example, if a bond has a coupon of 0% but trades above 100, its yield will be negative.
If you want to read more about how a bond yield is calculated, check out this link:
The Yield of a Bond
Spread (risk premium)
The spread, also known as risk premium, tells us the difference between the yield of a bond and the yield of a similar bond without any credit risk. By similar we mean that it will mature at a similar time in the future.
Government bonds denominated in currencies controlled by that government are considered credit risk free. If the bond is denominated in US Dollar, the risk-free bond will be one issued by the US government. If the bond is denominated in Euros, it will be a German government bond.
Our Apple bond has a yield of 4.56%. The bond spread is 92 basis points, which means 0.92%. This means that the annual (expected) yield on Apple’s bond is 0.92% higher than that of a U.S. government bond that is also due to mature in 2045.
The higher the risk premium (or spread) of the bond, the more we will receive above the “risk-free” investment, the greater the credit risk, and the lower the liquidity.
A detailed analysis of the risk premium can be found here:
The Spread of a Bond
Maturity is the date on which the bond issuer agrees to pay back the money it borrowed. It is a fundamental characteristic. When will we receive our money back?
Apple’s bond expires on in 2045. That is a long time from now. There is nothing wrong with buying bonds with very long maturities, as bonds can be sold at any time. But we must be aware of the risks.
The longer the maturity of the bond, the more its price will move. That is because maturity is the variable that most heavily impacts the duration of the bond, which we analyze below.
Duration here does not mean when the bond will mature. Though duration and maturity are heavily related.
Duration is indicated in years, and represents how long, on average, we must wait to receive all the money that the issuer will pay us until maturity.
We know that our Apple bond will mature in 2045, 22 years from now. But we will also be receiving 3.75% of interest every year for over 2 decades. If we take all those cash flows into consideration, the average time we must wait to receive that money is 15 years.
However, the interesting thing about the duration metric is not that. Duration tells us what percentage the bond price will move if the yield of the bond changes by 1%. Hence, it is used as a measure of risk in the event of changes in interest rates or spreads.
Our Apple bond, with a duration of 15 years and a yield of 4.56% will behave as follows: if the yield rises to 5.56%, we can expect its price to drop by 15%. But if the yield falls to 3.56%, its price will increase by about 15%.
As a result, if we expect a fall in interest rates, we will want to buy bonds with long durations. Imagine buying a bond with a duration of 30 years and rates falling by 2%. The expected price appreciation would be around 60%.
You will find an in-depth analysis of the duration metric in this post:
The Duration of a Bond
Credit ratings are determined by credit ratings agencies. The most famous are the American Moody’s, S&P and Fitch.
A credit rating tells us how much credit risk a bond has. The best rating, the famous AAA, indicates the highest credit worthiness. Below that, but still decent, we have AA, A and BBB. Bonds with BB and B ratings are considered junk. And bonds with ratings at CCC or worse are considered distressed.
The Apple bond, with an average rating of AA+, is believed to be of high credit quality. This means very low risk of default.
A complete analysis of credit ratings can be found here:
The Credit Ratings for Bonds
I hope you found this post on how to analyze a bond helpful. I invite you to subscribe to my newsletter: