“Bonds are Confusing” is perhaps the most common thing heard from others at HiLine Capital Management. We are undertaking an initiative to provide – in plain English as best we can – the necessary elements about bonds and bond investing. In our minds, there are 10 elements judged necessary to understand the “big picture” as it relates to lending, bonds and bond investing.
This Insight piece provides an outline or table of contents regarding the 10 elements that will be further expanded upon in a special Whitepaper: Beyond the Coupon that will provide further depth and the methodical foundation to better understand how bonds work and how to assess risk in bonds.
The 10 elements include;
- Investors with savings in the bank may want to “earn more” by lending money to a borrower. And often lenders come together to create a bond or partnership for raising capital.
- Bonds are a contract that outlines the terms and conditions of a bond. And it includes provisions for what happens when promises are broken.
- Bonds have a stated coupon or rate of interest, which is determined by several factors. And counterparties, except US Federal Gov’t would be considered to have some form of credit risk and higher rate of interest.
- Bond math is based on net present value principles which is the cost of money.
- Yields summarize total return. Yield is the combination of the net present value derived from coupon payments and return of principle are different than bond coupon.
- Duration is a risk profile or characteristic that quickly summarizes exposure to inflation and interest rate risk. It describes the price sensitivity to changes in interest rates.
- The discount rate represents a baseline opportunity cost and is fundamental in calculating net present value. And inflation represents most of baseline interest rates.
- Bonds are often traded on the secondary market, just like stocks. Since most bonds are traded in the secondary market a degree of liquidity exists.
- Bonds issued by the same counterparty carry vastly different risk profiles.
- Due diligence are based on 5 key variables derived from traditional bank lending standards and a few metrics may summarize various degrees of safety.
In Summary: A good bond investor must assess and invest, which is another way of saying “how do you reduce and mitigate bond risks in the pursuit of generating additional income and returns”…….and do so safely.
