How can you successfully evaluate prices and returns, understand and assess risks and choose bonds issuances and issuers?
At first glance, tackling the bond market may look relatively ‘easy’. The bond market, when compared to others, is often perceived as safe as issuers promise the repayment of invested capital, although the repayment is not always guaranteed. However, when you take a deeper dive, you will soon find out that in order to invest confidently, thorough analysis and understanding is needed.
The bond world, like any investment sector, offers different return opportunities. The more risks you take, the higher the return. Identifying risks in a tight timeframe is challenging, especially when you take the intrinsic and extrinsic factors that can either aggravate or reduce these risks into account. Identifying these key factors, even before the markets have discounted them, is key.
One of the key concepts is time value of money and time impact on both the price and the yield of the bond instrument. Key factors to take into account when it comes to time value of money include inflation.
Prior to investing a sum of money, one must look not only into the investment performance, but also into inflation. Making an investment decision over a period of time – be it 6 months, 10 years or even longer – means considering various factors, such as the investment return or the amount of money received at the end of the period, which needs to be adjusted to the inflation rate for that period. If the return on investment is higher than the inflation, you will have met your objectives; otherwise, the future value of your return on investment will be less than the present value, or today’s amount. In other words, when inflation goes up, a higher return will be required to maintain its real purchasing power.
Buying a bond is a solid alternative to depositing money in a bank current account. Therefore, when you decide to buy a bond, apart from inflation, you also need to look at the type of issuers you are lending your money to, be it a public or private entity.
The issuer borrows the principal and agrees to periodically pay (weekly, monthly, annually, every semester or term) an interest or what can also be referred to as a coupon. Once the bond reaches its maturity or expiry date, the issuer returns the capital initially received.
The market consists of different types of bonds. If the issuer is a State or a public administration, we refer to them as government or semi-government bonds. If, on the other hand, the issuer is a company or a bank, we refer to them as credit or corporate bonds. The type of issuer defines the issuing risk, which is the risk to which the investor is most exposed to because it is related to the solvency of the issuer itself.
By buying a bond, an investor becomes the lender of the issuer and is exposed to the risk of insolvency, in which case the issuer cannot honour its payment commitments. A valuable tool for assessing the solvency of the issuer is grade given to it by specialised rating agencies, such as Standard & Poor’s, Moody’s, Fitch, Dagong or DBRS. Typically, these rating agencies use a grading scale that ranges from “AAA” (maximum reliability) to “D”, the lowest rating also known as default situation.
In the absence of other risk factors, the price of the bond can be affected by the deterioration of the issuer's financial situation and/or overall rating, before maturity; a lower rating would hence, result in a lower bond price.
Together with EUWAX AG, a subsidiary of Boerse Stuttgart, LuxXPrime aims to provide investors with all of the information mentioned above so as to make informed investment decisions surrounding retail-sized securities. Combining the listing tradition of LuxSE and the trading expertise of Boerse Stuttgart, LuxXPrime provides investors with a stable and secure trading platform by guaranteeing increased protection through market surveillance, real-time monitoring and supervision of all trading activity. To learn more about LuxSE’s trading window LuxXPrime, to search the list of bonds and calculate their respective yield, visit the dedicated website at www.luxxprime.com.
Article by Luigi Campa Markets - Product & Client Development Manager The Luxembourg Stock Exchange
