Arctic's Bond Academy
Many people find bond investments difficult to understand, and we will do our best to help you. In this article we have provided some basic knowledge about bonds and the characteristics of these types of investments. We hope this can be useful when considering investments in fixed income funds.
What is a bond?
A bond is a loan.
A company’s projects can be financed by equity or debt. The two most common forms of financing are bank loans and bond loans.In the case of a bank loan, it is the bank that lends the money and thus becomes the lender to the company. The company pays interest and deductions to the bank.
In a bond loan, the company issues a bond. The bond is a security with a loan agreement which investors can buy. Investors thus borrow money and become lenders to the company. The company then pays interest to investors through the term of the loan. Bond loans usually do not pay deductions, so at the expiration of the loan, the entire loan amount is paid back to investors.
Bonds are securities that can be traded on the second-hand market.
Bonds can be bought and sold even after they have been issued, similar to the purchase and sale of stocks.
An investor receives interest payments from the company as long as the investors own bond shares. The price of the bond shares is based on expected future payments from the company in the form of interest and repayment of the loan. If an investor sells its bond holdings to a new investor, it is the new investor who becomes the company’s counterparty and who will receive the future interest payments. The investor who owns the bond when the bond expires will also get the bond loan repayed from the company.
The characteristics of the bond market inclines most people to invest in bond funds rather than individual bonds.
Unlike stocks, which are often traded on the stock exchange, bonds are traded directly with bond brokers by phone or in their own chat channels. The bond market is therefore less accessible to individual investors, and the complexity of making direct trades often makes the requirement for minimum investments high.
The investors in bonds are usually specialized bond funds, such as Arctic’s fixed income funds, other types of investment funds, or pension funds. Some private investors who invest larger amounts also trade bonds directly.
A good option for most investors is to invest in bond funds, such as Arctic's fixed income funds. There, the minimum deposit requirement is low and you get a well diversified bond portfolio. Hence, you are not as dependent on individual loans getting repayed as planned, and the fund reinvests interest and loan amounts continuously as these are paid from the respective companies.
What is a Bond Fund?
A bond fund invests in several individual bonds.
Bond funds invests in many different bonds. These are paid for with the money that fund investors have invested in the fund. By investing in several different bonds, the fund has borrowed money to several different companies, rather than borrowing all the money to one company. The fund thus gives investors exposure to a diversified portfolio of bond loans. The investor’s risk of fluctuations, default and loss of invested capital is therefore much lower than by investing only in one bond, because you are less dependent on each bond delivering as expected.
Expected risk and return are generally linked. Strong companies with a high probability of complying with their payment obligations generally receive lower interest rates on their loans than companies that are not expected to pay their obligations at the agreed time with the same certainty. Because the returns to bond investors are based on the interest rate paid by the companies, one would expect to get somewhat higher returns (interest rate) if one takes on a higher risk.
Arctic has three different fixed income funds with different risk and return profiles.
Arctic Nordic Investment Grade invests in the safest corporate bonds – so-called "investment grade" bonds. These bonds are loans to solid companies and swing little in course.
Arctic Return is a liquidity fund that invests in corporate bonds with a short time to maturity. The fund is expected to give a return slightly above our investment grade fund. This is a good alternative to a savings account in the bank, but with a higher expected return.
Arctic Nordic Corporate Bond is a medium-risk corporate bond. This fund has the highest expected return of our bond funds, but will also fluctuate more in value. However, the expected fluctuations and risk is significantly lower than for equity funds.
Bonds vs. Stocks
Bonds are different from stocks by the return being predetermined.
For a bond loan, interest payments and the time for repayment of the loan are regulated and disclosed in the bond agreement. The return to the bond investor is a result of the interest rate on the bond and the price the investor pays for its bond shares.
For an equity investor, the return is determined by the dividends paid by the company and the price development of the stock. However, there are no official requirements for the company to pay dividends, when to pay dividends, or how large they may be.
While the bond investor knows that she will receive fixed payments and that the amount initially invested will be repaid at the maturity date, the equity shareholders do not know what values they will receive. As a shareholder, you are left with the remaining value in the company after the creditors (e.g. banks and bond investors) have gotten theirs.
Bonds have priority over equity.
Before shareholders can withdraw dividends from the company, the company must have paid interest and deductions for the respective period. In this way, it is ensured that those who have borrowed money to the company will get repaid what they are entitled to. This is called priority. If the company goes bankrupt, the bondholders will therefore have the right to their money before the shareholders.
The Interest Payment
The return on a bond stems mainly from two elements; interest payments and price development. If you buy the bond when it is issued and hold until maturity, the underlying interest rate of the bond will be your return. If you buy and/or sell the bond along the way during its lifetime. the price development will also be included in the return.
The interest payment is divided into two parts. One part reflects the underlying market rate. For Norwegian bonds, this is usually a three-month NIBOR. The second part, the risk premium, reflects the risk premium investors want to lend money to the company beyond the underlying market rate. This risk is referred to as “the spread.” The more risky the company is, the higher the risk premium will be.
The interest rate is set by a market of investors who at each bond issuance are involved in determining the risk premium for the interest payment. This is determined by the company (the borrower) and the investors (the lender) through an auction process held by brokers.
The lender can choose a fixed or floating interest rate. In the North, floating interest rates are most common. At a floating interest rate, the underlying market rate (NIBOR), and therefore the interest rate of the bond, will change throughout the bond period. In contrast, the interest rate of a fixed-rate bond will be held constant throughout the bond period.
For example, a company’s floating interest rate can be NIBOR + 4%. If NIBOR is 1%, the interest payment will be 1% + 4% = 5% per year.
If the underlying money market rate rises to 2%, the interest payment will be 6%, and if the underlying interest rate falls to 0%, the interest payment will be 4%.
When interest rates are low and an increase in interest rates is expected, bond investors prefer floating interest rates. This allows an investor to get gradually higher interest rates, and with that higher return, because the underlying market rate rises.
If, on the other hand, the interest rate level is considered to be high and it is likely that the interest level will fall, bond investors will prefer to have the greatest possible exposure to bonds with fixed interest rates. In this way, they will be able to continue to benefit from the returns from high interest rates even if the underlying market rate falls.