What are the bonuses?
1.- What are bonuses?
It is important to clarify some concepts before starting. Bonds are also called fixed income securities, debt securities, or loans. In turn, depending on the duration, these fixed income titles can be calledpromissory notes(when they have aduration less than 1 year),letters(when they have aduration less than 2 years) orobligations(when they have aduration greater than 10 years). The bonuses arefixed-income securities for which the buyer acquires the right to return the total amount of his investment on the expiration date, as well as the right to previously agreed interest payments, which are known as the coupon. The bonds are distributed through banks and serve as a financing instrument for the entities that issue them, the issuers.
There are two types of bonuses:
-
public bondsor also called State bonds, which are those issued by States and other public entities with the aim of financing the general State budget or other public budgets.
-
private bondsor also called corporate bonds and are issued by companies to finance mergers or acquisitions or to finance expansion costs.
If, for example, the company XYZ SA wants to expand or has an innovative idea for a new product and needs 4 million Euros with which to build, for example, a new production plant, a warehouse and to be able to sell that product. Company XYZ has two options when it comes to covering that financial need of 4 million, increase its own capital by issuing moreActionsand giving entry to new shareholders or borrowing by asking for a bank loan or issuing bonds. In most cases they are carried out jointly.
By issuing bonds, the company receives money, which it must repay to investors at the end of the term along with interest on the borrowed money or coupon. Unlike thedividendsof companies, the payment of the coupon is mandatory regardless of whether the company is doing well or poorly. When buying bonds, the investor, or in this case also called the bondholder, becomes a creditor of the issuing entity and its work is similar to that of banks.
2.- Components of the bonds
A bond is basically made up of three components: The first is thenominal value, the second is thecouponand finally theduration.
2.1.- Nominal value
The face value is thevalue assigned to the bond at the time of issuance. In the example of company XYZ SA, if the nominal value is €1,000, company XYZ will issue 4,000 bonds and the investor can buy them at €1,000/bond. This is also the amount of money that the investor receives at the end of the maturity term.
2.2.- Coupon
The coupon is theamount that the investor receives for the interest generated by the bond. The coupon payment depends on the type of bond, usually the couponit is usually annual. In American bonds, the coupon payment is semi-annual. The term coupon has its origins in the fact that the old issues of loans in the form of physical titles included in the supporting document that each buyer was given a series of small coupons in which each of the coupon payment dates was recorded, as well as as its amount and that had to be cut and delivered to the bank to obtain that amount. Obviously, this system has not been used for years, since it has been replaced by the accounting annotation system and electronically, although the term coupon has been maintained.
In the example of the company XYZ SA with a bond of nominal value of €1,000 and an annual coupon of 4% with a duration of 5 years. Then the bondholder receives €40 each year for each €1,000 nominal value bond that he has purchased and so on for 5 years. At the maturity of the bond, that is, at the end of the fifth year, the €1,000 face value is also reimbursed. In other words, the bondholder obtains a €40 coupon plus the redemption of the face value of €1,000, for a total of €1,040.
Depending on the type of bond, interest is not always fixed, but can also be variable, for example, those associated with an index such as EURIBOR, these bonds are calledfloating coupon bonds. The distribution of interest can occur periodically throughout the duration, as we have seen in this example, or also on the maturity date of the bond. The latter, which do not pay interest during their life, but do so in full on the maturity date, are calledzero coupon bonds. Taking our example above, you would simply receive €1,200 on the expiration date of the bonus.
2.3.- Duration or maturity period
The third element of bonds is their duration or term to maturity. In general, the bonds have a duration of between 3 to 7 years. This period can also be much longer. There are government bonds with a duration of 30 years or more. This does not mean that you have to wait 30 years to recover the invested capital. Fortunatelythe bonds can be bought and sold through the Stock Exchange. For this reason,the bondslike stocks toohave a price tag, but this is not measured in Euros, like that of shares, but in percentage.
3.- How can I earn money with the bonuses?
We return to the values of our previous example. If the buyer acquires a bond with a face value of €1,000 and the market value is 100%, then he will have to pay €1,000, which is also what will be reimbursed on the maturity date. If the trading value is at 95%, then you will only have to pay 95% for the €1,000 nominal value bond, that is, €950. You will have bought the bond cheaper than its face value and part of the coupon benefits, you will obtaining a capital gain thanks to the trading value. This type of surplus value can not only be obtained in the purchase but also in the sale. When a bond appreciates, its market value increases and if the holder of the bond sells it, there will be obtained a capital gain.
Here it is observed that with a bonus you can earn money in two different ways, onewith the collection of the couponand another, more speculative,with the capital gains due to the quoted value.
4.- Risks and risk rating
Despite being fixed-income financial assets and knowing in advance what the return on investment will be, investing in bonds may have certain risks since they are not guaranteed financial assets. Just because it is a fixed income asset, does not mean that it is an investment without risk. What are these risks?
1) The first risk isinflation risk. If the inflation rate is greater than the interest on the bond, the bond's yield for that year will be negative.
2) The secondriskis heliquidity in the market. If there is not a lot of supply and demand, it can take days to buy or sell a bond.
3) But undoubtedly the most important risk is thecredit risk, that is, the possibility that the issuer of the bond cannot meet the payment of the coupons or the principal capital and it is for this reason that there are bonds with higher yields than others. The following table shows the yield on 10-year government bonds from different countries. Government bonds from Japan or Spain pay lower interest to their holders than those from Brazil, which currently stands at over 9%. This difference is mainly due to the so-called credit rating.
The qualification of the countries is carried out by therating agencies, among which the most famous are for exampleStandard & Poor's,Fitch RatingsandMoody's. These rating agencies assess the probability that the respective country will not be able to pay its debts (bonds) or will only partially pay them in the future.The lower the rating, the higher the risk.
While there is also the potential for speculation with bonds, they are generally less risky and less volatile financial assets than stocks. Also, in the event of insolvency, bondholders are creditors and as such are always paid off before shareholders. It is for these reasons that they are widely used to minimize the risk in investment portfolios of conservative people with a greater aversion to risk or by people close to retirement age, who seek a fixed return at low risk. They are also used by many stock investment fund managers to reduce the risk of such funds.