Bonds: a practical guide to understanding debt securities

What are bonds

Bonds are debt securities representing a loan issued by a private company or public entity to finance its activities. A person who buys a bond becomes a creditor of the issuer, who agrees to return the invested principal at maturity and to pay interest periodically, according to the terms. This type of investment is popular because it allows the issuer to obtain financing and the subscribers to access a return without becoming owners of the company, unlike investments in stocks.

The key elements of bonds

Bonds have some key elements that define their structure and returns. Among the main ones are:

• Nominal interest rate: can be fixed or variable and determines the amount of the coupon, i.e., the periodic payment that the issuer makes to the holders of the security. In the case of a fixed rate, the coupon amount remains unchanged throughout the life of the bond; in the case of a variable rate, the coupon amount can change, often indexed to benchmarks such as Euribor.
• Duration: Each bond has a fixed maturity. At the end of the term, the issuer must repay the nominal amount of the bond to the investor. Bonds can have short (less than 5 years), medium (between 5 and 10 years) or long (over 10 years) maturities.
• Coupon: represents the periodic payment stream to the investor. Some bonds, such as zero-coupon bonds, do not have periodic coupons, but allow for a return by purchasing them at a lower price than their face value.
• Mode of redemption: may be in a lump sum at maturity or through progressive redemptions. In some cases, redemption may be early, in the case of callable bonds, which are bonds callable by the issuer before maturity.

Variety of bonds available in the market

There are multiple types of bonds, each with specific characteristics that meet different investment needs. The main ones include:

• Ordinary bonds: provide for regular coupon payments and repayment of principal at maturity.
• Zero-coupon bonds: do not pay periodic coupons and are sold at a lower price than face value, offering a return based on the purchase price and the value at maturity.
• Convertible bonds: allow the holder to convert their bond into shares of the issuing company on predetermined terms.
• Indexed bonds: the yield is linked to the performance of a benchmark index, such as inflation or Euribor.
• Variable-rate bonds: offer interest that varies over time based on parameters such as the inflation rate or other market indices.

Risks and benefits of investing in bonds

Investing in bonds can have both benefits and risks. Among the main advantages is the stability of cash flows for the investor, since bonds provide periodic coupon payments and repayment of principal. However, the return on bonds tends to be lower than equity investments, since the investor does not take ownership risks.

On the other hand, there are also risks, including credit risk, or the possibility that the issuer may not be able to repay principal or coupons. Bonds issued by less solid companies, known as junk bonds or junk bonds, often offer a higher yield to offset this risk. Interest rate risk is another source of uncertainty, as a rise in rates reduces the market value of fixed-rate bonds. Liquidity risk, on the other hand, can occur when a bond is difficult to sell without losing value, especially in the case of lesser-known bonds or those with limited trading volumes.

Conclusions

Bonds are one of the most popular financial instruments for those seeking a safer return than stocks, but it is important to carefully evaluate the associated risks.Choosing the right bond depends on one’s risk appetite and investment objectives: some categories are ideal for those who want steady, predictable flows, while others are more suitable for those seeking higher return opportunities but accepting greater uncertainty.

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