Investing in bonds

A government bond is issued by a government, usually to cover a budget deficit. Belgian government bonds are issued in euros. There are also US government bonds in dollars, German government bonds (in euros), and bonds from less-developed countries in their own currencies. The European Central Bank also issues bonds that have become known as Eurobonds.

Corporate bonds generally work the same way as government bonds. With a company, the risk that the company will be unable to repay the loan is often greater than it is with a government. However, this depends on their creditworthiness (you can read more about this below). This higher risk is reflected in a higher potential (coupon) rate.

As an alternative to buying individual government bonds or corporate bonds, there are investment funds and ETFs that invest in several bonds at the same time. This means your investment is better diversified.

We have previously said that in a normal situation, you will get your money back. But what is a normal situation, and what isn't? This is all about the financial health (creditworthiness) of the issuing institution. If the issuing institution is financially sound, they will pay the interest every year and repay the principal on the redemption date.

However, the worse the issuing institution's creditworthiness, the higher the risk that it will be unable to pay the interest each year and unable to repay the principal on the redemption date.

To determine whether an issuing institution is financially sound, there are special rating agencies that give the bonds a rating. Well-known rating agencies are Standard & Poor's, Moody's Investors Services and Fitch Ratings. They use letters and numbers to indicate an issuing institution's creditworthiness. AAA is the highest creditworthiness rating, while C is the lowest. With a D rating, the institution is already bankrupt.

What the ratings tell you:

• The higher the creditworthiness, the greater your certainty of getting your money back.
• The lower the creditworthiness, the greater (credit) risk you run of getting your money back. This higher risk is therefore usually offset by a higher coupon. Of course, you are only willing to take higher risks if you expect to be rewarded with a higher interest rate.

• The table below shows which codes the rating agencies use for creditworthy issuers (investment grade) and for non-creditworthy issuers (non-investment grade bonds or high-yield or junk bonds).

The return on a bond is determined by a number of factors:

• The coupon – the interest rate of the bond
• The price of the bond
• The remaining term to maturity and redemption

The term coupon dates back to the time when bonds were still printed on paper. The coupon shows the interest rate, which is also known as the coupon rate. You receive the coupon interest regularly (usually annually) on a fixed date (the coupon date).

The price indicates the value of a bond as a percentage of the original nominal value. This will not always have to be the amount you paid when you bought the bond (your investment). 

A bond with a principal of €1,000 and a price of 98% is therefore worth €980 at that time. Most bonds are redeemed on maturity at 100%. However, the percentage sign is often omitted when the price is displayed.

It's worth remembering that if the price is 100%, this is also called 'at par'. If the price is lower than 100%, however, this is called 'below par'. And if the price is higher than 100%, this is referred to as 'above par'.

It goes without saying that a loan has to be repaid. The remaining time to redemption (repayment) is the term, while the date on which the redemption takes place is called the maturity date. A loan with a longer term to maturity is more risky than one with a short term to maturity. This is reflected in a higher coupon (interest rate).

Bond prices are constantly changing. This is partly due to changes in interest rates on the capital markets – the market interest rate. In general, the following applies:

• If the market interest rate rises, the price of the bond will fall.
• If the market interest rate falls, the price of the bond will rise.

How far prices move depends on the bond's remaining term to maturity:

• The further into the future the redemption date of the bond lies, the more sensitive the price of the bond will be to a change in interest rates.
• As the bond comes closer to the redemption date, the more the price will settle around 100%. In this later phase, market interest rates will have little impact on bond prices.

In addition, any changes in the issuing institution's creditworthiness plays a major role – especially if the creditworthiness deteriorates, as this could result in a sharp drop in prices. This is because it is becoming more uncertain whether the issuing institution will still be able to repay the principal.

• Liquidity risk:
  The liquidity of the bond, the ability to buy or sell a bond during its lifetime, is very variable. It depends mainly on the volume of the issue (the larger the issue, the more efficient the secondary market), the transaction volume and the type of issuer (government bonds can generally be traded more easily during their term than bonds issued by individual companies).
  
  
• Price risk:
  This risk depends on the remaining term of the bond (the further away the bond is from maturity, the more sensitive the bond will be to interest rate fluctuations) and the issuer's current financial situation (bond prices react negatively to any deterioration in the issuer's rating and to the risk that it may deteriorate).
  
  
• Exchange rate risk:
  You only need to deal with this risk if a corporate or government bond is denominated in a foreign currency. Currency exchange rates fluctuate every day. If the currency in which the bond is listed falls in value, you may receive back less than your original investment in your base currency. This risk is also present at the time of payment of each coupon.
  
  
• Interest rate risk:
  This can result in a loss for the bondholder and is therefore greater in the event of a sale before maturity. The value of an issued bond falls when market interest rates rise. The longer the remaining term of the bond, the greater its sensitivity to interest rates.

• Tax on stock exchange transactions (TST):
  Tax applicable when buying and selling bonds on the secondary market.
  
  
• Withholding tax on interest:
  In Belgium, withholding tax is charged on interest payments. Interest on bonds issued by foreign companies is charged first in the country of origin and then in Belgium. Some of this can be claimed back from countries with which Belgium has signed a double taxation treaty that includes provisions for its repayment.
  
  
• Brokerage fee:
  The cost of executing your orders on the secondary market.
  
  
• Custody fee:
  The fee for holding an instrument in a custody account.
  
  
• Sales and placement commissions:
  When you buy a bond on the primary market, you pay a placement fee. Together with the nominal value, this constitutes the issue price.
  
  
• Capital gains tax:
  If you sell bonds at a profit before maturity, you do not have to pay any tax on this. Note that you must pay withholding tax on the difference between the purchase price and the redemption of a zero-coupon bond.