How bonds are created

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Let’s walk through the creation of a bond using an example.

Company A is hiring aggressively, and needs more office space to fit all the new employees. It’s looking at renting two more floors in the building where its headquarters are. They calculate that the cost of the floors over the next 5 years will be 5 million euros. That’s a big investment, and more than they have in free cash right now. They could go to the bank, get a loan, and pay 3.5% interest on it.

But there’s a better option available to them: do a 5 million euro bond placement at 1.8%, almost half of what the bank would demand.

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This is how it breaks down:

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They offer 50,000 bonds worth 100 euros each. Each bond carries an annual interest rate of 1.8%. That means each year, the bondholder receives 1.80 euros. At the end of five years, when the bond matures, they get their 100 euros back. Add to that the 1.80 euros they got each year, and the investor got 109 euros for a 100 euro investment.

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That’s bonds in a nutshell. Let’s go even deeper.

This is where it gets interesting because the price of the bond can fluctuate just like a stock can. What doesn’t change is the amount you’re paid. So let’s say someone bought the Company A bond for 100 euros. Company A runs into a bit of trouble, and the person isn’t sure they’ll get their 100 euros back in five years, so they sell their bond to you, for 95 euros. You still get 1.80 euros every year, and 109 back in five years, but your interest rate is now 1.9%. This is what we call the bond’s yield. The 1.80 euros is the coupon. The day you get your money back is the maturity date.

Interest payments can be paid from once to 12 times a year, as the company decides. Most often, it is done twice a year or quarterly, so twice or four times a year.

Because you can sell a bond at any time, you’re not necessarily holding it until maturity — until the day the company or state gives you the money back, the broker writes your bond off and replaces it with the money value.

So what happens when you sell a bond between the days when you’re supposed to receive an interest payment? Simple, the money you would have gotten, called accrued interest, is calculated into the price. For example, if you held your Company A bond for half a year, and then sold it, the person who you’re selling it to would get the full 1.80 euros payment, even though you held the bond for the same time. So you take your portion, in this case 90 cents, and add it to the price you’re selling it. If you’re selling at par — the original price of the bond, you’d get 100.90 euros for it.

Similarly, when buying, if you buy a bond from another investor, you compensate them for part of the coupon.

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How to understand how much you can earn on a bond

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Because bond prices fluctuate, but the money you get at maturity doesn’t, it’s important to keep an eye on the bond price and figure out how much you’ll earn on it. If you buy a bond for 110 euros but only get 109 euros back at the end, you’ve lost money.

Similarly, you almost never buy a bond right at the beginning of its issue, which means you’ve likely missed a few interest payments already. That’s where the yield to maturity comes in. It’s a formula that tells you how much money you’ll make if you buy a bond today and hold it until its maturity date. The formula is simple enough, but there are also dozens of calculators online that can do the math for you.

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Who can issue bonds

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The issuer of the bonds determines the yield. The more reliable the issuer, the lower the coupon rate it will offer and the lower the yield on the bond. This is simply because of the risk. Like in everything, investors want a higher yield for higher risk. If you’re going to risk losing all your money, you want more money as a reward if you don’t. So companies that are almost certain to repay a bond are usually not going to pay extremely high interest rates. Companies that are not as financially healthy, or have defaulted on debt in the past, by contrast, have to offer higher interest in order to entice investors to buy their bonds.

Issuers can be roughly divided into three categories: federal, municipal and corporate.

Federal bonds are issued by the federal government, usually by the country’s treasury. When someone talks about a German 10 Year bond, they mean the German federal bond with a 10-year maturity. These usually have the lowest yields, depending on the country, as countries are the least likely to go bankrupt. There are exceptions of course, such as Venezuela, whose 10-year bond has a yield over 10%, while the German 10-year currently has a yield of -0.5%.

Municipal bonds are like federal bonds in that they’re issued by governments, but in this case by states or cities. They don’t have the heft of a whole country behind them, but are usually seen as pretty reliable.

Corporate bonds are, as the name implies, issued by companies. These can range in quality from investment grade to so-called junk bonds — bonds that are seen as too risky for certain investors like pension funds that can’t afford to lose a lot of money, but might be valuable for investors with more risk appetite.

Companies can also issue bonds in currencies other than their home currency. If that happens, it’s called a eurobond. This has nothing to do with the euro currency, mind, but is used for any bond that’s issued in a foreign currency. So if a European company issues a bond in American dollars, it’s still a eurobond. In this case, it gets the particularly confusing name of eurodollar bond.

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Different types of bonds

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At first glance, it may seem that bond investing doesn’t give a big return and is unnecessarily complicated. This might be true if you’re only looking at European federal bonds. But corporate bonds, depending on their rating, can still have a yield that’s higher than a savings account would give you.

Those without experience in bond buying tend to buy a low-yield bond and hold it to maturity. This way, price swings don’t affect you, as you know how much money you’re getting at the end. Keep in mind that even though bonds are generally safer assets than stocks, they are not risk-free.

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Other important information:

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Taxes

Bonds are, like stocks, taxed as capital gains. Individual countries have different rules and incentives, so it’s important to look exactly at how your country taxes bonds.

In Germany, bonds are taxed with the 25% Abgeltungssteuer, the capital gains tax. However, there is a tax-free amount first, which right now is 801 euros for single people and 1602 euros for married couples. Anything over that amount is taxed. You also owe normal social security contributions and church tax, if you pay it.

In France, treasury bond gains are taxed at a flat 12.8%, in addition to the 17.2% social security contributions rate. Alternatively, you can opt to have your gains taxed at your income bracket level, though this decision can’t be reversed.

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Amortization

Amortization is when the issuer returns the value of the bond not on the maturity date, but gradually in parts. A mortgage is an example of this. This of course reduces the risk you won’t see your money, but it also presents a problem in that you need to find somewhere else to invest the returned money.

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Puttable bonds

A puttable bond gives you the right to redeem the bond at par (original) value with the issuer on a predetermined date or if specific conditions are met, without waiting for the maturity date. For example, if you bought a bond with a maturity date in 10 years and a put date in three years. This means you can redeem the security in three years. In this case, your earnings will be three years worth of coupons plus face value. Or you can not redeem the bond and hold it for another 7 years, while receiving coupons.

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Alright, it’s quiz time. Let’s see if you paid attention.