The fifth and final part of our series on financial products and practices Ever heard anyone talk about investing in stocks and bonds? It is a relatively common expression, but one a lot of people only half-understand. Everybody knows what stocks are and why you might invest in them. But what are bonds? Be honest, do you really know? Bonds are debt instruments. If Nocash Corp wants to borrow money, it has two main options: it could ask a bank for a loan, and in return get a lecture about things like the challenging liquidity environment. Or, it could issue a bond. Issuing a bond is a bit like issuing shares except shares are equity and bonds are debt. Instead of asking one or two banks to lend it some money, Nocash Corp asks a load of investors if they would like to buy bonds. And buying a bond is making a loan. If you hold a HK$1,000 bond issued by Nocash Corp, Nocash Corp owes you HK$1,000. Simple. Bonds have a few important features that theoretically enable investors to decide whether to buy them or not and at what price. These features are the price, the face value, the coupon (another word for interest), the rating, maturity and the yield. The simplest features are the price and the face value. You might think the price of a HK$1,000 bond would be HK$1,000, but it rarely is. The price you pay for a bond is often less than its face value. This is particularly apparent in the case of bonds that do not pay interest. If you are the government of Debtistan and you want to borrow money to build some roads and hospitals and things, you might consider issuing a government bond. Now, you probably do not want to pay interest every year to the people who buy the bonds, so you issue what is called a zero-coupon bond, basically a bond that does not pay interest. Now if I am an investor, I am not going to buy a HK$1,000 bond from you or anyone else if all I can expect to get back is my HK$1,000 in three years. I want to get a return. If I can't get it in interest, I will get it in capital gains. So when you sell me a HK$1,000 bond, I might only pay you HK$900 for it. Assuming you do not go bankrupt before the bond's maturity - which is the time when you have to pay me back - I will get HK$1,000 from you in return. The HK$100 difference is my return on investment. Once I have bought the bond, I can theoretically sell it to someone else. But the price I can sell it for will depend on the market's perception of the credit quality of Debtistan. If the Debtistan economy starts to improve and the treasury's coffers start to fill up, the credit quality of Debtistan will be perceived to have improved and I might be able to sell my HK$1,000 bond for HK$950, and make a HK$50 profit. However, if six months after I buy the bond there is a coup and the new regime announces that it will not consider itself bound to any of the tyrannical capitalist lending arrangement made by the previous government, then the most I will be able to get for the Debtistan HK$1,000 bond will probably be about HK$1.50. Of course, not all bonds are zero-coupon and the interest or coupon a bond pays is also pretty important. If you buy shares in Nocash Corp, you are generally entitled to receive dividends, assuming they declare some. Dividends are based on how well the company performs and how much cash it has left over at the end of the year. As such, dividends are uncertain and how much the company pays to shareholders is really up to its board's discretion. The interest payments on bonds on the other hand are fixed at the time they are issued. Whether the company performs well or poorly, it still has to pay bondholders whatever rate of interest the bond requires. Interest rates and issue price are supposedly based on the credit-quality of the company or the government issuing the bond. And the way this is normally expressed is through a credit rating. A bond rated AA+ will pay a lot less interest than a bond rated BB-. When a company is planning to issue a bond, it will generally go to one or all of the big rating agencies and ask them to provide a rating, which they pay for. Investors then largely rely on the rating agencies' opinion in deciding how much interest or discount is appropriate for that bond. I do not want to get into whether this is sensible or whether agencies ever make mistakes, but the AAA-rated sub-prime mortgage-backed bonds were not a good example of this system working. The other important factor is the maturity. Maturity is the time at which the issuer has to pay back the face value of the bond to bondholders. If Nocash Corp issues a three-year bond with face value of HK$1,000, no matter how much they sold it for or how much it is trading for, at the end of the three years they have to come up with HK$1,000 for each bondholder. A lot of the time they will do this by issuing a new bond, but that is another story. The return on investment that a bondholder will make then is the interest, if any, that the bond pays, plus any capital gains in the bond's price. Suppose Nocash Corp issues three-year bonds with a face value of HK$1,000 and a coupon, or annual interest rate, of 5 per cent. If one year after they are issued you buy one of these bonds for HK$980 and hold it for two years, you will make a HK$20 capital gain and receive a total of HK$100 in interest, a total return of HK$120. In this scenario, before buying this bond your broker will tell you the 'yield'. This can mean a few different things but will generally mean either the 'current yield' or the 'yield to maturity'. The current yield is the annual interest rate the bond pays, based on your purchase price. In this scenario the current yield is not 5 per cent. It would be 5 per cent if you purchased the bond for HK$1,000, but bonds pay interest on their face value, not their purchase price. So here, the bond pays HK$50 a year in interest, but your purchase price is HK$980, so the current yield is 5.1 per cent. This is interesting if all you want to know is how much interest you will earn. But if you want to know your total return, including capital gains, you would look at the yield to maturity. Yield to maturity is the total return you will make on your purchase of the bond up until it matures, and so includes capital gains. This is one of those complicated calculations that includes a net present value element and is too complicated to be carried out by anyone other than a maths genius, an analyst with a financial calculator in his hand or anybody else who can type 'yield to maturity' into Google and find an on-line calculator. Anyway, for our bond, it is 6.1 per cent. The slightly counterintuitive thing about these calculations is that as the price of the bond goes down, the yield goes up and vice-versa. If the price of this bond was HK$900, rather than HK$980, the current yield would be 5.5 per cent and the yield-to-maturity would be 11 per cent. The reason for this is simple - the lower the price, the higher the interest payments are as a percentage of the price, and the larger the theoretical capital gain. When people say that bonds 'dropped', the tricky thing is whether they mean bond prices dropped or bond yields dropped, which mean opposite things. And just like every financial instrument, there are an uncountable number of permutations of the bond. So how do you buy bonds? They are not like shares in that you cannot buy bonds on the internet. Instead, you need to go through a broker. Depending on how popular a particular bond is, your average bond broker will be able to buy bonds for you at market price in a similar way a broker might buy shares for you at market price. And just like when you buy shares, your broker adds his fee into the price you end up paying. And finally, why would you buy bonds? In the past, investment advisers would tell you that bonds are more stable than equities. I am not sure they say this any more, as bond prices have plummeted thanks to the recent crisis. These days investment advisers say the only place to get decent interest, since the banks have pretty much decided to stop paying interest on deposits, is in bonds. And this is true, kind of. The missing piece of information in this statement is that bonds are not risk-free. The obvious twist is that the higher the interest rate, the higher the risk. And just like shares, bonds can go up in value and down in value, and just like shares, when issuers go bankrupt, bonds can end up being worth very little. What's in your nest egg? Convertible A convertible bond is generally one which starts out its life as a bond but at some point can be converted into equity in the bond issuer, at a predetermined price at the bondholder's discretion. Callable A bond that can be redeemed by the issuer. If Nocash Corp issues a callable bond with a 5% coupon and interest rates drop to 4%, Nocash Corp would be able to buy back the callable bonds, probably to reissue them at a lower interest rate. Inflation-linked Usually issued by governments, they generally pay a lower interest rate than normal bonds, but the investors' return is linked to inflation. The higher the inflation rate, the higher the yield. Mortgage-backed Bonds backed by a pledge of mortgages and payable from the issuer's general funds. Step-up A bond that pays two or more rates of interest. It might pay 3% interest for the first three years, and then 5% for the next three. Junk A junk bond is relatively riskier and usually has a credit rating of less than BB. These are often called high-yield bonds as they tend to pay more interest because of their low credit quality. Floating-rate While most bonds have fixed interest rates or coupons, some can have an interest rate that moves over time. A floating-rate bond's interest rate will be defined by reference to an index, such as LIBOR + 0.20%. Bearer If you are a villain in a movie, you will demand the ransom in bearer bonds. These things really exist and were once very popular. Whoever has possession of a bearer bond at the time of its maturity is entitled to repayment of the principal. Subordinated Not all bonds are created equal. It is possible for Nocash Corp to issue two sets of bonds that have different rights to repayment. If Nocash Corp issues a standard bond and a subordinated bond, the standard bond (called senior) gets paid first and the subordinated bond gets paid only if there is enough money left over. The subordinated bond is riskier and so has a higher yield.