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Fixed income financial instruments: bonds

Let's continue our consideration of financial instruments with fixed income.

And in this material: for what purposes and how can a novice investor invest his money in bonds?

What are bonds?

As you already know, in addition to bank deposits, bonds are a classic financial instrument with fixed income.

Bonds- These are securities that establish a loan relationship between the company that issued the bonds and the investor.

For reference. A company that has issued any securities (including bonds) is called issuer valuable papers.

In relation to bonds, the issuer undertakes to return the borrowed money on the announced date (the bond maturity date), and also undertakes to pay the investor who invested the money in the bonds interest in the form of coupons for bonds.

The amount that the issuer agrees to pay investors when the bond matures is called par value of the bond.

Coupons for bonds are paid at a pre-declared interest rate and this interest is calculated on the face value of the bond, regardless of where and at what price the investor bought it.

Typically, coupons are paid every six months.

The method of making a profit on bonds is very similar to the option with a bank deposit. We buy bonds and hold them until maturity, periodically receiving interest payments, that is, just like a bank deposit with interest payments once every six months.

However, there are a number of significant differences between bonds and a bank deposit.

First difference investment in bonds from investing money in bank deposits is that bonds are not protected by the Bank Deposit Insurance System. This means that if the bond issuer has problems with payments, he will have to deal with this issue on his own: sue the bond issuer, participate in bankruptcy proceedings, or simply accept the loss of the invested funds (in whole or in part).

For this reason, the relationship between risk and return is much more visible in bonds: the higher the likelihood of problems for the issuer, the higher the yield on its bonds.

That is, by taking on a higher risk, you can get a higher investment return on your investment. And you can protect yourself from losses without the Bank Deposit Insurance Agency, using the usual diversification of your money investments.

If you buy bonds of not one, but several different bond issuers (for example, 20), then in the event of problems with one of the issuers, investment losses will amount to no more than 5% of the amount invested in bonds, and these losses can be completely covered by coupon payments.

Another difference bonds from a bank deposit is that the issuer cannot be forced to repay the bonds early.

Therefore, if you urgently need money invested in bonds, the only thing you can do is try to sell the bonds on the financial market. If, of course, there are people willing to buy these bonds at an acceptable price.

Practice shows that in a calm economic situation, finding a buyer for many types of bonds is not difficult.

Moreover, when selling bonds, part of the profit accumulated on the bonds at the time of sale is automatically included in the transaction price.

That is, unlike a bank deposit, where interest on the deposit is lost if you withdraw money before the period specified in the deposit agreement, you can withdraw money from the bond market without losing accumulated income.

Let me emphasize once again that this applies to a calm financial market; in times of financial crisis, the rapid sale of bonds is fraught with serious losses. But statistics show that the bond market is quiet most of the time during the year.

Types of bonds

The classic type of bonds are coupon bonds with constant coupon.

Coupon bonds with a constant coupon - on the amount of debt (also known as the face value of the bond), investment income is regularly accrued in the same amount, for example, 10% per year (bond coupon).

It is clear that coupon bonds with constant coupon bonds are popular with issuers and investors in stable and predictable economic conditions.

When the financial market is turbulent, they are used more often coupon bonds with variable coupon.

Coupon bonds with variable coupon - The size of the bond's coupons changes during the period of circulation of the coupon bonds on the stock market. There are many variations of variable coupon bonds.

All these variations of variable coupon bonds share common principles:

• at the time of payment of the next bond coupon, the investor can find out the size of the next bond coupon, and
• this bond coupon amount is determined in accordance with the rules published at the time the bonds are issued.

The simplest example of a variable coupon bond is a coupon bond, in which the issuance decision simply lists all of the bond's coupons from issue to maturity.

These bond coupons may gradually increase or decrease during the period of circulation of the coupon bond on the financial market in accordance with the issuer's views on the prospects for changes in interest rates on the financial market.

If a general decrease in interest rates in the financial market is expected, then it is quite possible to set decreasing coupons on a coupon bond.

If the majority of investors expect increased instability and an increase in interest rates in the financial market, then in order to attract investors, the issuer will probably have to offer them coupon bonds with increasing coupon payments.

The size of coupon payments on coupon bonds can be tied to any indicator: the exchange rate, the inflation index, the level of market interest rates.

Also very common coupon bonds, the coupon for which is determined by a decision of the Board of Directors of the issuing company.

That is, before the next bond coupon is paid, the Board of Directors meets and a decision is made on the size of the next coupon.

Of course, investors may wonder whether the bond's coupon will be set at a ridiculously low level (for example, 1% per annum)?

Legally, the issuer of a coupon bond has every right to declare a bond coupon of any size. But, if the decision taken infringes on the interests of investors, then it will put an end to the reputation of the bond issuer, which will make further borrowing on the financial market impossible. In addition, very often the moment of making a decision on the coupon rate of a bond coincides with the so-called date bond issuer's offers.

Bond issuer offer– the issuer’s obligation to buy bonds from any investor willing to sell them at a predetermined price (usually at par) on a specified date.

The presence of an offer from the bond issuer gives confidence to investors, since it guarantees the opportunity to sell bonds at the offer price without waiting for the redemption date in the event of a sharp change in economic conditions.

Sometimes there are bonds whose income is paid not in the form of coupon payments, but in the form of the difference between the sale price and the par value ( zero coupon bonds, or zero coupon bonds).

Zero coupon bonds- the issuer sells bonds at a discount (that is, at a discount), and repays them at par, thereby ensuring investors receive profit from the bonds.

Typically, such zero-coupon bonds are issued for a short period (for example, a year).

Discount Bond– the difference between the bond price and the par value, if the bond price is lower than the par value. If the market price of a bond exceeds its face value, then the excess of the bond price over the face value is called a premium.

Sometimes investors are offered convertible bonds.

Convertible bonds- bonds that, under certain conditions, can be exchanged for other financial assets at a predetermined price.

The most common are convertible bonds, which can be exchanged for shares of the issuer. Of course, an exchange makes sense only if the market price of the issuer's shares is higher than the price at which the shares can be obtained as a result of converting bonds.

Convertible bonds can, in principle, bring very good returns, but usually the price of exchange of bonds for shares is set at a level significantly higher than the current market price, and the coupon rate on such bonds is much lower than the rate on ordinary bonds of the same issuer.

Thus, it makes sense to buy convertible securities only in anticipation of a sharp increase in the issuer's shares.

How can a novice investor make money in the bond market?

As you already understand, the profit from investing in bonds consists of two parts:

• from coupon payments and
• from the difference between the purchase price of the bond and the face value received when the bond is redeemed.

Profitability = ((ΣCoupons+Nominal-Price)/Price) x (360/Time) x 100%,

Coupons– these are all expected coupon payments until the bond matures;

Denomination– the face value of the bond, paid at the time of maturity of the bond;

Price– bond purchase price;

Time– term until maturity of the bond, expressed in days.

As you can see, the bond purchase price is in both the numerator and denominator of the formula. This leads to the fact that as the purchase price of the bond decreases, the estimated yield of the bond increases.

That is, if we see a rise in yields in the bond market, this may mean that market participants are getting rid of bonds and, as with any sell-off, this causes bond prices to fall.

On the one hand, this gives us the opportunity to invest money in bonds more profitably. But on the other hand, this is an alarming signal: a sell-off in the bond market may indicate a deterioration in the economic situation in the country.

Not to mention the fact that if we have already invested money in bonds, then the increase in market yields suggests that if we urgently need money, then most likely we will only be able to sell bonds at a loss.

Fluctuations in bond prices can be caused not only by crisis events.

Since all parts of the financial market are closely related to each other, a change in the level of interest rates in any segments of the financial market will cause corresponding changes in the bond market.

For example, if interest rates rise in the interbank lending market, then investors will sell bonds and transfer money to interbank loans until, due to lower prices in the securities market, bond yields equal the yield of the credit market.

When market interest rates fall, it is quite possible that the price of bonds rises above their face value.

When buying such bonds, we receive a loss due to the fact that when the bonds are redeemed, we will receive an amount less than what we paid for the bonds.

But this loss will be completely covered by coupon payments on bonds, and the final yield will be fully consistent with the current level of interest rates in the markets for financial instruments with fixed income.

Since bond prices can rise or fall depending on economic conditions, there is an opportunity to profit from these fluctuations.

During periods of rising interest rates, it is possible to sell bonds in order to buy them later a little cheaper. Conversely, if interest rates are expected to decrease, you can buy bonds and sell them in the financial market at a higher price immediately after interest rates decrease.

Thus, we can obtain returns from bond speculation that exceed those from buy-and-hold-to-maturity investing.

However, unfortunately (or perhaps fortunately), it will not be possible to achieve a significant increase in the yield from operations with bonds through speculation.

Unlike the bank deposit market, there are no interest-capitalized securities in the bond market. Therefore, if we want our investments in bonds to grow using the “compound interest effect,” then we need to constantly remember that the profits received must be immediately invested somewhere.

How can a novice investor buy and sell bonds?

The easiest way to buy or sell bonds is through the stock exchange. Most bonds of Russian issuers are traded on the Moscow Interbank Currency Exchange (MICEX), access to which can be easily obtained using the services of any brokerage company.

Bonds can also be purchased on the so-called “over-the-counter” telephone market, but the transaction amounts in this case must exceed 5 million rubles.

To gain access to exchange trading, you must select a brokerage company that is a participant in exchange trading and enter into an agreement with it for brokerage services (brokerage agreement).

In a brokerage agreement the basic principles of interaction with a brokerage company, the amount of broker commissions for various types of operations on the securities market, the composition of the broker’s reporting to the client, and much more will be spelled out.

Important! The brokerage agreement must be signed in paper form, with a real signature, and not by “pressing a button on the website.”

After concluding a brokerage agreement, the investor (speculator) can be provided with an electronic digital signature, with the help of which all interaction with the brokerage company can be transferred to the sphere of electronic document management via e-mail or some kind of electronic document management system.

Attention! But that comes later, but first the brokerage company must see your real signature on a real paper agreement.

The contract can be submitted to the company by mail.

In the modern financial market, almost all securities are issued in non-cash (book-entry) form and are stored as entries in DEPO accounts in depositories.

Therefore, in addition to the agreement for brokerage services, it is also necessary to conclude a contract with a brokerage company agreement for the storage of securities (depository agreement).

The depository agreement deals with the opening and maintenance of a DEPO account in which securities purchased at exchange trading will be stored.

In the recent past, securities were sometimes issued in bearer form (that is, in the form of paper documents), which could be kept either in depositories or at home.

Transactions with these securities could be carried out not only through the stock exchange, but also through various agents of the issuer (in particular, in the case of domestic government savings loan bonds, such functions were performed by Sberbank of the Russian Federation).

The circulation of bonds in paper form caused a lot of problems for issuers (from verifying the authenticity of securities presented for redemption to organizing the payment of income and redemption), therefore such bonds are currently not issued.

Choosing a brokerage company is a responsible matter, but its importance should not be exaggerated.

If you do not like the service at your chosen brokerage company, you can always change broker.

You can transfer your assets to an account with another brokerage company by submitting the appropriate instructions to the depository where your securities are stored.

After signing all the necessary documents with the brokerage company, you have the opportunity to carry out transactions with any securities traded on Russian stock exchanges.

As a rule, a brokerage company provides clients with two options for making transactions in the exchange’s trading system:

• by phone and
• through an electronic trading system (Internet trading system).

When a transaction order is given over the phone, the actual execution of the transaction falls on the shoulders of the brokerage company's employees.

If an electronic trading system is used, then client orders enter the trading system of the stock exchange without the mediation of brokerage company employees.

Typically, telephone orders are used when dealing with large blocks of securities, when wanting to buy securities on the over-the-counter market, or when dealing with illiquid assets.

The method of submitting an order to a brokerage company also determines the minimum transaction size:

• If an Internet trading system is used, then the minimum size of an exchange transaction is determined by the exchange and usually ranges from 1,000 to 5,000 rubles.

But the brokerage company is not at all interested in accepting orders for such small amounts over the phone.

For each completed transaction, the brokerage company takes a commission, expressed as a certain percentage of the transaction amount.

The usual broker's remuneration for operations performed in the online trading system is about 0.04% of the transaction amount.

You can make transactions at any time during the trading session of the exchange. Trading on the MICEX takes place every working day from 10 a.m. to 6:45 p.m., and soon the MICEX exchange plans to extend the trading session until 24:00 p.m., thus making the stock market available to private investors most of the day.

Selecting bonds for investment

Since our investments in bonds are not protected by the Bank Deposit Insurance Agency, the choice of bonds is a rather responsible decision for the investor.

After all, if you buy bonds of an issuer that cannot pay off its debts on time, this will mean that you will not be able to return your investment in full and, in addition, you will have to spend time and effort on litigation with the issuer of these bonds.

For reference. Default– refusal of the debtor to fulfill all or part of the obligations under the issued bonds.

Ideally, in order to make an informed decision about purchasing bonds, you should conduct a thorough analysis of the financial condition of the issuer.

Finding the information necessary for such an analysis is not difficult, since the issuer of bonds is obliged to provide investors with complete information about itself. However, not every private investor can carry out this analysis, since it requires highly qualified financial analysts.

If you are unable to independently analyze the financial condition of the issuer, do not be discouraged.

Most brokerage companies are willing to help their clients make investment decisions.

In addition, the results of the work of professional analysts can be found in the public domain on the Internet. Based on the opinions of professionals, you will be able to make adequate decisions about investing money in the bond market.

Another criterion for the correctness of the decision made on investing in bonds is the correspondence of the level of profitability to the level of risk.

Most of the transactions in the stock market are carried out by professional investors and it can be assumed that with their transactions they establish the correct risk-return ratio.

This means that the higher the yield on the chosen bond, the higher the likelihood of problems. Therefore, when choosing bonds, you should be extremely careful when considering bonds with increased yield.

Any Internet trading system has a function for calculating the “current” bond yield.

That is, you can not waste time on making calculations, but simply look at the bond yield calculated based on the price of the last transaction in the trading system.

And it is quite possible to set the entire list of bonds to be sorted by yield and thus get sorted by risk. But you need to be careful: when calculating profitability, the system relies on the price of the last transaction.

And if the last transaction with a bond was a very long time ago, then the yield will be calculated incorrectly. The fewer transactions are made on a bond during a trading day, the higher the likelihood that the yield calculated by the system will differ greatly from the actual yield.

So, if you sort the list of bonds by yield, then at the top of the list there will be bonds of the largest and most reliable issuers.

These are the so-called “first tier” bonds, or “blue chips”. Blue chips are the most sought after by professional investors and receive the most trades during the trading day.

The yield on “first-tier” bonds is low and is quite comparable to the yield on deposits in Sberbank of the Russian Federation (about 4–5% per annum).

Higher returns can be obtained by investing in bonds of the “second” and “third” tiers - bonds of smaller issuers that are less popular with investors.

Investing money in bonds of the “second” and, especially, “third” tier is more risky, but also more profitable.

“Second tier” bonds can bring a profit of about 6–9% per annum, and “third tier” bonds – up to 13% per annum.

Also in this list you will definitely find bonds with a colossal yield to maturity (for example, 30% per annum or more).

As you know, high bond yields are a consequence of the fact that bonds are sold at low prices.

Thus, a yield exceeding the level of yield on “third-tier” bonds indicates that the issuer, for some reason, has lost the confidence of investors and they are trying to get rid of such bonds as quickly as possible.

As the bond market moves deeper into the echelons, not only does the risk of default increase, but problems associated with bond liquidity also increase.

For reference. Liquidity– the ability to quickly sell bonds at the current market price.

Blue chips can be easily bought and sold at the market price at any time. Urgent sale of “second-tier” bonds is fraught with a loss of up to 10–15% of the nominal value of the bonds, and in an unstable economic situation these losses are likely to be greater.

“Third tier” bonds are even more difficult to sell, and here it is quite likely that it is impossible to sell the bonds in principle due to the lack of buyers (this means that it will be necessary to wait for the maturity date of the bonds).

What are the bonds secured by?

Nothing and everything. There is no collateral attached specifically to the bond issue in the form of a pledge of any assets of the issuer.

But, on the other hand, we can say that all assets, all property of the issuer serve as security for its debt obligations in the form of bonds. True, bondholders act here on an equal basis with any other creditors of the issuer: its suppliers and contractors, banks, tax authorities, and so on.

Why do bond investors need rating agencies?

Theoretically, the decision to purchase bonds should be made by the investor based on a comprehensive study of the financial condition of the issuer.

However, not every investor can carry out a qualitative analysis, since this process requires high qualifications and also requires collecting a large amount of information about the bond issuer.

And here rating agencies come to the aid of investors. Employees of rating agencies monitor the state of affairs of a huge number of companies, assess their creditworthiness and assign a letter or numerical rating to the analyzed company (for example, AAA, or Va3, or BB-, and so on), reflecting the likelihood that the company will be able to cope with its obligations .

For reference. Creditworthiness– the company’s ability to meet its obligations, that is, to make all necessary payments on loans, bonds and all other debts on time.

Today, the three leading international rating agencies enjoy the greatest confidence among investors: Standard & Poors, Moody's and Fitch Ratings.

What should a private investor do if the issuer does not pay on bonds?

In normal economic conditions, defaults are extremely rare. During the period from 2001 to 2007, only 5 defaults occurred on the Russian market. But during the 2008 crisis, the number of defaults quickly exceeded a hundred.

You should not take the terrible word “default” as a synonym for the words “loss of all investments.” Default “merely” means the issuer’s failure to fulfill its obligations when due.

• more informed investors begin to quickly sell off securities, which leads to a significant drop in price.

The buyers of such bonds are other informed professionals who intend to actively participate in the issuer's bankruptcy proceedings (or who have reason to believe that the issuer will be able to cope with difficulties and pay off the bonds with only a slight delay).

Accordingly, for a private investor in such bonds there are two possible options in this situation:

• sell bonds without waiting for default, or
• participate in court proceedings and bankruptcy proceedings of the bond issuer.

The fall in the price of a bond when problems arise with the issuer can be of very different depths.

For example, problems at an oil refinery could cause the bond price to drop 15% to 25% of the bond's face value.

In 2008, the difficulties of the Wild Orchid company led to a drop in the price of the company's bonds to 25% of par, while RBC bonds dropped at the same time to 2% of par.

The bankruptcy of the issuing company also does not always lead to a complete loss of investments in the bonds of this company.

For example, during the bankruptcy of Yukos OJSC, all bondholders of the company were able to return their investments (although the bankruptcy procedure lasted for approximately two years), but during the bankruptcy of Kredittrust Bank, bondholders received nothing.

In general, the more real assets (real estate, equipment, inventory, etc.) the issuer of bonds has, the greater the likelihood that in the event of bankruptcy the company will be able to return at least part of the funds invested in the bonds.

What taxes must a private investor pay on bond transactions?

Profits on bonds are subject to personal income tax (PIT) at a regular rate of 13%.

But for government bonds of any level (bonds of the Russian Federation, regions and republics, as well as municipalities and districts), a special taxation procedure applies:

• Only the profit generated due to the difference between the price of the bond and the par value is subject to personal income tax, and coupons are not taxed.

The fact that profits on bonds are subject to personal income tax should be taken into account when making a decision to purchase bonds: buying bonds with a yield of 10% per annum will be less profitable than placing money on a deposit with the same yield.

Why should a private investor buy blue chip bonds if their yield is significantly lower than inflation?

Indeed, why would anyone buy “first-tier” bonds if their yield is significantly lower than inflation?

Those who cannot afford to lose a single ruble and who need to invest large sums of money (for example, several hundred million rubles) are forced to invest in first-tier bonds.

In addition, those who must do so based on legal requirements (for example, Russian non-state pension funds and insurance companies) invest in “first-tier” bonds.

Another category of potential buyers of “first-tier” bonds are organizations that have access to borrowing at very low rates: banks, insurance companies, professional participants in the securities market (especially foreign ones).

For a private investor, the first-tier bond market is not of particular interest.

Where can a private investor find information about the bond market?

Since bonds are traded on the exchange market, the main source of information about current yields and bond prices are exchanges (MICEX and RTS).

Investors can receive exchange information both directly (for example, from an Internet trading system or on the exchange website) and indirectly, with the help of various information agencies providing information about the financial market as a whole (RosBusinessConsulting - rbc.ru, Interfax - interfax.ru) , or specializing exclusively in the bond market (cbonds.ru, rusbonds.ru).

On the websites of specialized information agencies you can easily find information about each bond issue: maturity dates, payment mode and coupon size, financial statements of issuers and much more. These same sites publish a large number of analytical reviews about the bond market.

Why should a private investor invest money in bonds if there are bank deposits?

A well-diversified portfolio of second-tier bonds may well provide a return that exceeds the return on bank deposits at a comparable level of risk (or with a lower risk, in cases where the investment amount significantly exceeds 700,000 rubles protected by the Bank Deposit Insurance Agency).

Of course, we are talking about increasing the profit received by only a few percent, which may not seem like a significant enough result to spend time establishing a relationship with a brokerage company and participating in exchange trading.

However, if we are talking about long-term investments (5 years or more), then an increase in profitability by even 1%, especially taking into account the effect of “compound interest,” will give a quite noticeable increase in profit on investments.

In addition, using bonds as part of an investment portfolio, it is much more convenient to transfer money from the stock market and from derivatives to fixed income instruments.

For example, if there is reason to believe that investments in stocks will not bring the expected profit in the near future, then, of course, it makes sense to sell off your stock portfolio (usually part of the portfolio).

Since money just sitting in a brokerage account doesn't generate any profit, you might decide to temporarily put your spare cash in a bank deposit.

Transferring money from the broker to the deposit will take 2-3 days and, what’s a shame, if you want to buy shares again, the deposit agreement will have to be terminated early and the money will be transferred back to the brokerage account. Transferring money from account to account will take about a week, and as a result, you may not receive a penny of additional income.

If you use bonds instead of a deposit in this situation, then everything will be much simpler: you sell shares and immediately buy bonds.

When the need arises again to replenish the investment portfolio with shares, simply sell bonds (keeping the accumulated interest income) and buy the necessary shares.

Another advantage of bonds over deposits for a private investor, which may seem somewhat strange, but, as practice shows, this is a very serious factor:

• bonds protect our money from ourselves better than deposits.

Since in order to withdraw money from the securities market, we need to perform several more actions than to withdraw money from a deposit, our money is safer in cases when we urgently want to buy something “incredibly necessary”.

The differences between bonds and deposits are especially noticeable during economic crises.

When the situation is unstable, investors get rid of securities en masse, and this leads to the opportunity to buy bonds of reliable issuers at a low price and thus make a very good profit.

Deposit rates also rise during the crisis, but to a much lesser extent.

For example, in 2008, deposit rates rose to 18–20% per annum, while at the same time it was possible to buy a portfolio of quite reliable bonds with a yield of about 40% per annum (which, in particular, made buying bonds just as profitable investment option, as well as buying foreign currency during the “acute phase” of the crisis).

So:

• If you do not want to take risks at all, but want to invest your free funds, then in a stable economic situation it makes sense to think about using fixed income instruments - bank deposits and bonds.
• However, it should be remembered that fixed income instruments (bank deposits and bonds) are not protected from inflation surges.
• Fixed income instruments (bank deposits and bonds) can be used to diversify investments and reduce the overall risk of an investment portfolio.
• For these purposes, it is more convenient to use bonds, and bank deposits are more often used to store cash reserves for emergencies (creating a “safety cushion”).
• It is extremely difficult to obtain a profit that significantly exceeds inflation losses using fixed income instruments (bank deposits and bonds).
• The ability to invest small amounts of money makes bank deposits and bonds convenient tools for accumulating capital.

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What kind of income do securities bring?

Different securities make money in different ways. Before investing, study what determines the income of a particular security.

What is income? Types of income from securities

Revenue is the difference between revenue and costs. It comes in two types: current - for a period and final - for all time. Calculated in monetary units.

The following types of income from securities are known:

• dividends;
• change in exchange rate;
• interest;
• discount;
• premium and margin.

They depend on the type of paper.

Income from shares

A share is a security that allows you to receive part of the company’s profits, since its buyer automatically becomes a co-owner of the company.

There are two ways to make money on shares: dividends and resale of securities at an increased market price.

Dividends

Dividends are part of the profit that the company pays to shareholders based on the results of the reporting period.

According to the type of shares, dividends are:

• ordinary;
• privileged.

The amount of dividends is set by the board of directors at the general meeting of shareholders. Preferred dividends can be fixed and do not depend on the profit of the enterprise. They are paid first.

Based on the frequency of payments, dividends are divided into:

• annual;
• semi-annual;
• quarterly.

More often than not, dividends are paid annually.

According to the method of payment, dividends are:

• monetary - paid in cash;
• property - paid in shares, goods or property rights.

By size, dividends are divided into:

• full - paid in full;
• partial - paid in parts.

The terms and procedure for payments are determined by the company's charter or meeting of shareholders. The dividend policy of each company is individual.

If an organization has no profit for the last period, it can pay dividends from retained earnings from previous years or from special funds. On the contrary, a company can save profits if it needs money for development.

You will receive dividends even if you have held the shares for only a few days. The main thing is to have time to get into the register of shareholders.

Change in market price

If a company does not make a profit, it cannot pay dividends. Then the only way to make money on its shares is to resell them for more than the price at which they were purchased.

The market price is formed as a result of trading and depends on supply and demand in the market. The better a company performs, the higher the demand for its shares and the more they will be worth. If things go wrong for a company and the stock price begins to fall, it is better to sell them immediately. And if the price rises, buy again and resell at a higher price.

You can earn money both ways. Let's say you bought a share for 1000 rubles. A year later, you received a dividend of 100 rubles and resold the share for 1,200 rubles. In total, your income was 300 rubles.

Bond income

Unlike a shareholder, a bondholder is not a co-owner of the company, but a creditor. There are two ways to earn income from bonds:

• a fixed interest rate that the company undertakes to pay throughout the life of the bond;
• the difference between the market and par prices of a bond, or the purchase and sale prices.

Coupon payments

Dividends are paid on stocks, and coupons are paid on bonds. Only, unlike dividends, coupons are mandatory payments.

They are:

• fixed - the same amount is regularly paid, which is set in advance;
• variable - the payment amount may change.

Coupons, like dividends, are paid quarterly, half-yearly or annually. The coupon income is accrued every day, but is paid on a certain date.

The coupon amount depends on the size of the company. The larger the enterprise, the lower the coupon payments on its bonds.

Price difference

As with stocks, bonds make money through price changes. On a specific day, the company buys the bond from you at a set par price, or pays the amount in installments if the bond is amortizing. The main thing is to purchase a bond at a price below par. Then the difference between the purchase price and the face value paid - the discount - will be your income.

If a bond has zero coupon, it usually sells for significantly less than face value. And the earnings from price changes are impressive. But most often such bonds are issued by companies close to bankruptcy.

It is not necessary to hold the bond until the end of the term; you can sell it at any time and make money on the difference between the purchase and sale prices. But if the bond is coupon, you will lose further interest payments and you will have to transfer the accumulated coupon income to the new owner.

Income from mutual funds

For mutual funds, income is generated through the activities of management companies. They consider all types of securities income to obtain the greatest return for clients. Each management company has its own methodology.

Shareholders earn from the increase in the value of the share. If the prices of securities in the assets of a mutual fund rise, the value of its shares increases. The investor's income consists of the difference between the purchase price and the price at which he sells the increased share back to the management company. But the value of the share may fall, then the investor will be at a loss.

Shareholders do not receive dividends or interest.

Income from other securities

Securities reflecting loan relationships

Interest and discount are the main types of income from securities that establish a loan relationship between the seller and the buyer. In addition to bonds, these include bills of exchange, certificates of deposit, and savings certificates. Anyone can buy bills of exchange, savings certificates are purchased by individuals, and deposit certificates are purchased by legal entities. Unlike a certificate, the holder of a note cannot pay it off at any time without cost.

Interest rates on these securities are determined by the Central Bank. You can receive income in the form of a discount if you buy securities at a price below par.

Securities giving the right of ownership

Securities that represent ownership rights include options, futures and warrants. The owners of these securities are either obligated, in the case of futures, or have the right, in the case of options and warrants, to purchase the assets within a specified period of time at an agreed price. Warrants are used to purchase securities; options and futures are used to purchase any assets.

As income, the seller receives a premium - a commission from the buyer, and the buyer makes money on the difference in value: he sells the asset at a more expensive price if it has fallen, or buys it at a lower price if it has risen. Option sellers or both parties to futures transactions may post margin, a guarantee that can be used to pay off a position if the other party defaults.

Where is it more profitable to invest?

Securities are more profitable than bank deposits because their income is higher. But it depends on the risk. The riskier the security, the more income it can bring.

There is virtually no risk on government bills. Low-risk include other government securities, medium-risk include corporate bonds. They are suitable for lovers of conservative strategies.

The highest risk is in stocks, options and futures, but these securities bring the greatest income.

The Right service helps you select stocks and bonds taking into account your desired risk-return ratio. Using simple questions, he determines the strategy that suits you, assembles and manages your portfolio.

Source: Board of Governors of the Federal Reserve System. Division of Research and Statistics; and Federal Reserve Bulletin, 1986, August, p.511-524. Chapter 24: Selecting Fixed Income Securities 281 debt levels were $26.3 billion), while $77 billion in equities were retired. The reasons for the decline in the net worth of corporations, only partly offset by the accumulation of retained earnings, were the takeover of companies, the buyout of companies on credit with transfer to the private sector, restructuring and the purchase of their own shares. As a result, financial leverage (that is, the percentage of debt in the capital structure) grew rapidly and the market for subprime subordinated debt instruments expanded accordingly. High yield bond funds have become one of the most popular members of the mutual fund industry. In 1985, corporate bond funds, mostly high-yield, increased their net assets by almost $9.5 billion. and amounted to 24 billion dollars. In 1986, their growth was equal to 17.5 billion dollars. Large buyers included financial institutions such as savings and loan associations and insurance companies. Interest coverage Interest payments When assessing creditworthiness, the traditional indicator of covering interest obligations with net profit before interest and taxes still remains central. But the adequacy of coverage criterion must be adjusted to take into account significant changes in the level of interest rates. Let's look at a simple example. In 1966, XYZ Industrial Company had net earnings before interest and taxes of $20 million, but the company had $100 million in assets. debt at a rate of 4%. Coverage of interest expenses, that is, the ratio of interest to net profit, is equal to 5, which means that the bonds can be classified as investment grade. Two decades later, XYZ Company had grown and was still thriving. Now its profit before interest and taxes was $60 million, and its debt had only doubled to $200 million. But as a result of operations to refinance old bond issues and place new ones, the average rate increased to 10%. The interest coverage ratio shrunk to 3 ($60 million in revenue divided by $20 million in interest liabilities), and as a result the company greatly reduced its investment status. (Note also that the economic benefits created by financial leverage have decreased significantly.) Statistics on the interest coverage ratio have lost almost all meaning. Moreover, this indicator has never been an adequate substitute for actual debt service coverage, that is, total interest costs plus principal repayment costs (assuming that the ability to service debt is not determined by 281 Part Three: Bond Analysis Table 24.2. Debt servicing costs (millions of dollars)

* To calculate the pre-tax equivalent of debt repayment costs, use the coefficient: 100/(100 - Tax rate), assuming that in 1966 the tax was 52%, and in 1986 - 46%. liquidation value of assets, but the ability to make a profit). If the debt of the LGK company in 1966 and 1986. to be repaid evenly over 10 years, debt service coverage could be calculated as in Table 24.2. It is common sense that when a company grows by 200% and only half of that growth is financed by debt, its creditworthiness, as well as the investment quality of its bonds, increases as a result of the increase in safety. If interest rates on the debt in 1966 had been closer to 1986 levels, then naturally the comparison would have favored 1986. Debt Servicing Shifting the focus from covering interest only to covering all debt servicing costs does not eliminate the issue of ratio sensitivity to the percentage value. In practice, the problem of complete comparability between borrowers and the position of one borrower in different periods does not have a general solution. When analyzing fixed income securities, this problem must be re-addressed each time and the “normal” debt service costs must be determined to minimize the volatility of coverage ratios. Recalculating reported interest payments on new Class A bond issues using a 10-year moving average assumption can be considered a normal interest level for these purposes if the issue of the credit impact of losses or gains from non-recurring issues is left to the side. events or from timely short-term entries into the capital market. The problem of large volumes of variable rate bonds is relatively new. The same problem often occurs with bank term loans. Since no one in the world is able to predict the level of interest 10 or more years in advance, the analyst can only accept some plausible hypothesis in this regard and begin quantitative tests. If a bond can only be classified as investment grade at the lowest interest rates, it should be rejected. And such a decision is all the more reasonable since the buyer of bonds already takes the risk of a possible future increase in market interest. To assess the dynamics of changes in a company's creditworthiness over a number of years, you can use a simple ratio - the ratio of the amount of debt to net after-tax profit, that is, an indicator of how many years the company needs to pay off its debts. Since we are ignoring interest expenses (although they are subtracted from net income available for distribution to shareholders), changes in interest rates have little impact on this figure. General Creditworthiness Criterion A company receives open access to capital markets at reasonable interest rates if it is able to repay all business obligations when due, while maintaining a certain margin of safety that guarantees solvency even in the event of adverse circumstances. It is up to the securities analyst to determine how adequate the margin of safety is relative to the actual business risks. It is clear that to assess stability and profitability, the analyst must analyze the company in its entirety. Assets as a Source of Payment A company's ability to pay off debts by liquidating assets is a useful indicator, but only if the value of the assets is largely independent of the value of the business as a whole. A captive financial company like General Motors Acceptance Corporation is not expected to pay off its debts with profits. In good years, such as 1985, net income amounted to only 1.4% of total debt. The margin of safety is formed not by the ability to make a profit, but by the excess of the amount of collected receivables over the amount of debt. Below is the calculation of coverage indicators 282 Part Three. Analysis of bonds debt (in billions of dollars). All assets except accounts receivable are ignored. Accounts payable to the parent company are included in secondary (subordinated) debt.

In addition, assets are a source of debt repayment in the following cases: payments for the extraction of natural resources; accounts receivable for the sale of manufactured products in installments; transport equipment - rolling stock on railways, aircraft and oil tankers; oil pipelines operating under a “take or pay” contract, that is, providing for a penalty for refusal to purchase; rental of equipment - communication and production, computer equipment; real estate mortgages. For the analyst, significant factors are the quality of the collateral and the creditworthiness of the user. The analyst's judgment about the creditworthiness of the bond issuer is based on the terms of the debt repayment agreement. When lending to airline aircraft purchases, for example, there is no need to secure loan repayment through lease agreements, conditional sale agreements, or collateral over movable property, unless, of course, the loan agreement deprives the borrower of the right to mortgage the aircraft. Modern equipment, if in good condition, is sufficiently liquid and provides good collateral for loans to airlines, which tend to have weak credit positions. Chapter 24 Selecting Fixed Income Securities 283 When there is excess oil tanker capacity, the collateral value of the tanker may fall extremely low, but if it is chartered without a crew by a major international oil company, the tanker will become prime collateral for the loan. This is a typical example of how creditworthiness depends on the ability of the user of the asset to service the debt. Income-backed industrial bonds have become an important capital market instrument today. The reputation of a little-known municipality or county is something intangible. The analyst's attention is required only by the one who is lending to him, as a rule, this is a large company. Securing a loan on property that the borrower owns and uses in his business adds little to the value of most debt instruments. The specialized property used is valuable only for its contribution to profit. The real source of creditworthiness is profitable activity. The right to pledged assets has also lost value as a result of changes in the bankruptcy procedure: today the dominant desire is to reorganize in order to save the business, instead of liquidating the bankrupt and paying debts in accordance with the seniority of claims. Under bankruptcy law, the transfer of pledged property to creditors may be delayed for quite a long period of time, and this reduces the potential value of the collateral. Therefore, a bond investor's first concern should be to avoid getting into a bad situation, rather than to seek protection in case such a situation does occur. So if a company's junior bonds aren't strong enough, it's probably not worth investing in senior bonds. You can put it another way: if the company is creditworthy, you should buy more profitable bonds, and these, most often, are just junior or minor obligations. Limiting investing to senior bonds is the same as declaring a lack of confidence in credit ratings. There's a caveat to be made about junior bonds: if the price for senior bonds is only to give up a little extra return, it might be worth paying for modest protection against unforeseen events. If an investor is concerned about the liquidity of bonds, then again it is worth preferring senior bonds in the expectation that their prices are less volatile. The ability to generate earnings as a source of payment For most corporate bonds, the source of payment is the company's earnings. A power plant serving an expanding territory can pay off its bond issue early by issuing another issue, but refinancing is possible for it 284 Part Three. A bond is analyzed only because the market knows about its ability to make a profit. Capital-intensive industrial companies are expected to repay their bond debt, although the amount of debt they place on the market may increase as the enterprise grows. Let's consider the statistics of default on bond loans (see Table 24.3). It is easy to see that debt defaults become more frequent during periods of recession or depression. It would probably be better to take the bond default rate for low-quality issues, but this also happens with investment-grade issues (see Table 24.4). The distribution of bond defaults by industry (see Table 24.5) shows that the dynamism and profitability of the industry do not guarantee success. It can be assumed that investors may be influenced by perceptions of the prestige of the industry, depriving them of the usual main- Table 24.3. Failure to fulfill obligations to repay corporate bonds

Source: Altman E.I. and Nammacher S.A. Investing in Junk Bonds. New York: John Wiley & Sons, 1987, p. 107. Table 24.4. Rating of outstanding bond issues (in%)

Source: Altman E.I. and Nammacher S.A. Investing in Junk Bonds. New York: John Wiley & Sons, 1987, p. 131. Chapter 24. Selecting Fixed Income Securities 284 Table 24.5. Corporate Bond Failure by Industry, 1970-1985.

Source: Altman E.I. and Nammacher S.A. Investing in Junk Bonds. New York: John Wiley & Sons, 1987, p.133. anxiety and causing them to take specific risks that they would otherwise consider unacceptable. An example is the story of Viatron Computer Systems. The company proposed, but was unable to supply, a cheap and effective system like the one that later turned out to be very effective. Viatron, however, was in bankruptcy the year it offered its convertible unsecured bonds to the market. Long ago, three criteria for creditworthiness were defined: collateral (assets as a source of debt repayment), profitability and character. The third criterion is too often considered given and assessed inadequately. One need not look to the Ivar Kreuger and International Match Corporation scandals to find examples of dishonesty in business. Equity Funding, Flight Transportation, Itel, Saxon, U.S. Financial, Westgate were responsible for 6% of bondholders' losses (see Table 24.5), and investor losses were even greater. The level of profitability that justifies investing in bonds depends on both business positions (industry position, customer relations, new product development, quality of marketing and management, etc.) and financial positions (liquidity, capital adequacy, pricing, cost control , profit planning, etc.). It is also important to take into account the state of the industry. Even this short- 285 Part Three. An analysis of the list of bonds suggests that a lot depends on the company itself. However, the question remains: is it even possible to measure the reliability of a company's ability to generate profits? It is worth turning to works devoted to predicting bankruptcies, since these works attempt to find those financial indicators that may warn of the possibility of corporate collapse. The seminal work of Beaver and Altman1 provides ample evidence that some combination of financial ratios can identify potential bankrupts in advance. The Altman Z-score was developed into the ZETA model, marketed by Robert Haldeman as the ZETA Credit Risk Score2. To obtain the final assessment, 7 financial ratios are used: 1) cumulative profitability - the ratio of the amount of retained earnings to total assets; 2) stability of profit - an indicator of the standard deviation of profit before interest and income for 10 years from the trend line, related to total assets; 3) capitalization - the average annual value of the market value of ordinary shares over a five-year period, calculated as the ratio of the total capitalization of primary obligations accounted for at par value or at liquidation value, and ordinary shares at the market price; 4) size - the amount of tangible assets; 5) liquidity - the ratio of current assets to current liabilities; 6) debt service - interest coverage ratio; 7) total profitability - the ratio of earnings before interest and taxes to total assets. In February 1987, average ZETA scores correlated with company credit ratings as follows:

1 Beaver W. Financial Ratios as Predictors of Failures//Journal of Accounting Research, 1967. January; Altman E.I. Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy//Journal of Finance, 1968, September. For a detailed review of the issue, see: Altman E.I. Corporate Financial Distress. New York: Wiley, 1983. 2 Zeta Services, Inc. 5. Marineview Plaza, Hoboken, New Jersey. ZETA model scores are regularly calculated for more than 4,800 companies. Chapter 24: Selecting Fixed Income Securities 286 The result of this analysis and identification of possible bankruptcy candidates is indicators that help the analyst identify companies that investors believe are candidates for credit rating upgrades or downgrades. If the ZETA-score value falls below 2.9, it means that the company’s rating is doomed to fall below BBB, that is, it falls out of the group of investment-grade securities3. The role of reporting indicators The security and reliability of loans can only be judged by data on the company’s performance. To determine the degree of security of a debt, the analyst seeks to measure quality indicators that have already demonstrated their reliability and thereby provide hope for the future. Investigating the possibility of favorable future developments is an activity for buyers of junk bonds and dubious stocks. In some cases, when we are talking about reputable and reliable borrowers, it is enough for the analyst to study the reported data on profitability and liquidity in order to establish the security of loans in the event of unfavorable developments in the economic situation. But normally, the only reliable sources of analysis are adjusted income statements and balance sheets. We have already discussed the necessary adjustments in Part 2 of this book. Reporting, especially when freed from embellishment, is also the best source for understanding development prospects. To explore the outlook, it is best to take the latest data on sensitivity to macroeconomic and industry factors. An analyst can learn a great deal from close observation of how a company responds to the vicissitudes of commodity markets. Debt Coverage: Stability and Volatility A bond buyer usually accepts the inevitability of interest rate risk, especially in the case of long-term bonds, but does not intend to accept credit risk, and even without adequate compensation. It is preferable to have a low but stable debt coverage ratio than an average high but highly volatile one. Criteria for assessing a company's ability to repay debt should take into account industry characteristics first (and company characteristics second). If, by the very nature of the business, the company receives a steady stream of cash, very little debt coverage is acceptable. It is precisely because of the stability of income that electricity producers demonstrate many examples of high quality 3 For a review of the ratings, see: Hawkins D.F., Brown V.A., and Campbell W.J. Rating Industrial Bonds. Morristown, New Jersey: Financial Executives Research Foundation, 1983. 286 Part Three. Bond analysis of high-quality bond issues. However, even in this area, the development of nuclear power plants has greatly changed the existing indicators of growth and stability. Life constantly reminds us that we cannot rely too much on traditional rules and relationships. Restructuring If a company radically changes the structure of its business or financing, the analyst has to rework and revise the most important statistical indicators. If it is possible to highlight a particular industry sector, some of the data for past periods can be used without radical processing. In other cases, the analyst must rely on his imagination and common sense to construct future financial statements. If the restructuring primarily affects the company's finances, the analyst's task is relatively simple. In the case of a company buyout on credit, for example, management does not have the opportunity to borrow funds, and the direction of business development is to a certain extent predetermined. A cap on capital investment is inevitable, and it will take some time to repay the loan taken to buy back shares. When there is relatively little crowding out of debt by equity in the capital structure, these types of consequences usually do not arise. Definition of Creditworthiness Corporate finance managers, lenders and investors benefit from a broad definition of creditworthiness. When it comes not to short-term speculation, but to investments in stocks and bonds, the investor must evaluate the following three factors: 1) the ability of the company, in the face of an unfavorable situation in the industry or in the economy as a whole, to continue operating without allowing large losses or reductions in production; 2) the company’s ability to meet current obligations for a sufficiently long time and service debt obligations even if an unfavorable situation arises; 3) the company's ability to access new sources of financing to update or expand its critical business areas even in the face of unfavorable situations. Since a reliable assessment of such factors is impossible in principle, when predicting the size and stability of future income, it is important to assess the degree of loan security.

Quick summary: So far we have discussed how differences in profit rates can serve as an indicator of currency price movements.

As the prevalence of bonds or interest rate differentials between two countries' economies increases, a currency with a high bond yield or interest rate tends to be valued more relative to the other currency.

Like bonds, fixed income securities are investments that offer a fixed payment at regular intervals. Economies that offer higher returns on their fixed income securities should attract more investment, right?

This would make its currency more attractive than that of other economies offering lower returns in their fixed income market.

For example, let's look at guaranteed securities and Euribor (Euribor - European Interbank Offered Rate, we're talking about UK bonds and European securities here!).

If Euribors offer lower yields than guaranteed securities, investors will be upset after investing their money in the eurozone fixed income market and will be more likely to invest their money in higher-yielding assets. This could cause the EUR to weaken against other currencies, particularly the GBP.

This phenomenon applies to virtually any fixed income market and any currency.

You can compare the yields on Brazilian fixed income securities and the Russian fixed income market, and use the differences to predict the behavior of the real and the ruble.

Or you can look at Irish fixed income versus Korean... And you'll get the big picture of what's going on.

If you want to try your hand at these, government and corporate bond data can be found at these two sites:

• http://www.bloomberg.com/markets/rates/index.html
• http://www.bondsonline.com

You can also check a country's government website to find out current bond yields. This data is quite accurate. This is the government. You can trust this data.

In fact, most countries offer bonds, but you're better off sticking to those whose currency is part of the major currencies.