Bonds for Beginners: What You Need to Know
Introduction
Bonds are debt securities that allow investors to receive fixed income and plan their finances. For novice investors in the Russian market, bonds represent a combination of relative safety, predictable payouts, and the opportunity for portfolio diversification.
In times of unstable stock markets, bonds serve as an "anchor" asset for the portfolio: they are less volatile than stocks and provide stable cash flow. This is especially important during periods of market turbulence, when stocks may sharply decline, while bonds maintain their value or even increase in price due to capital fleeing to safe-haven assets.
1. Basics of Bonds
1.1 Structure of a Bond
A bond consists of three key elements: face value, coupon rate, and maturity date. The face value is the amount that the issuer promises to pay the investor on the maturity date. The coupon rate, expressed as a percentage of the face value, represents the income the investor receives during their ownership of the instrument. The maturity date determines the final date for the return of the face value and concludes the payment cycle.
An additional parameter is the registration closing date for security holders. On this day, the list of owners entitled to coupon payments is fixed. If a trader purchases a bond after this date, they will not receive the next coupon and must take this into account when calculating yield.
1.2 Types of Bonds
Bonds vary based on issuers and payment structures:
- OFZ (Federal Loan Bonds) - issued by the Ministry of Finance of the Russian Federation, characterized by high reliability and liquidity.
- Corporate Bonds - issued by companies, with higher yields due to the credit risk of the issuer.
- Sub-federal and Municipal Bonds - used by regions and municipalities to raise funds for infrastructure projects.
- Mortgage Bonds - secured by a pool of mortgage loans, which reduces the risk of default.
Moreover, there are indexed bonds, where the coupon is linked to inflation, and convertible bonds, which give the right to exchange the bond for the issuer's shares at a pre-agreed price.
2. Calculating Yield
2.1 Coupon Income
Coupon income represents regular payments from the bond. If the face value is 1,000 ₽ and the rate is 8% per annum with semi-annual payments, the investor will receive 40 ₽ every six months. Total income for the year will amount to 80 ₽.
It is important to consider the payment calendar: reinvestment of coupons is possible only after the funds are credited to the brokerage account, which can take 1-2 business days. Therefore, when selecting a bond, it is important to consider not only the coupon size but also the payment frequency and the broker's clearing speed.
2.2 Yield to Maturity (YTM)
The yield to maturity (YTM) takes into account the current price of the bond, the coupon payment schedule, and the return of the face value. When the purchase price is below face value, the YTM will be higher than the coupon rate, as the investor receives additional income from the discount.
The YTM is calculated by solving the equation: the sum of discounted coupons and the face value equals the bond price. Professional investors often use Excel for tabulated calculations or specialized modules in trading terminals.
Example of YTM Calculation
If a bond with a face value of 1,000 ₽ and an annual coupon of 10% trades at a price of 950 ₽, the YTM exceeds 10%. The investor will receive 100 ₽ in coupon income and 50 ₽ from the discount, which collectively increases the overall yield.
2.3 Interest Rate Risk and Duration
Interest rate risk is defined as the sensitivity of a bond’s price to changes in market rates. Duration is the weighted average time until all cash flows are received. The higher the duration, the more significant the price change in response to rate fluctuations.
To reduce risk, investors typically select bonds with a duration of 2-4 years. This allows them to earn income from coupons while avoiding significant losses during sharp rate increases. Long-term bonds may have a duration of 8-10 years, making them excessively volatile for newcomers.
3. Investment Risks
3.1 Credit Risk and Ratings
Credit risk reflects the likelihood of the issuer defaulting on coupon or face value payments. Agencies such as Moody's, S&P, and Fitch assign ratings ranging from AAA to D. Ratings of BBB- or higher are considered investment-grade, while lower ratings are deemed speculative.
Investors can independently verify ratings on agency websites or their broker's terminal. When selecting corporate bonds, it is advisable to prefer issuances with ratings no lower than BBB to reduce the risk of default.
3.2 Liquidity and Spread
Liquidity is measured by trading volume and the spread between buying and selling prices. Bonds with daily trading volumes exceeding 100 million ₽ and spreads of up to 0.1% are considered highly liquid. Low-liquidity issues may be more expensive to buy and cheaper to sell.
It is recommended to analyze trading activity over the past 30 days and the presence of market makers providing quotes. If there is consistently low volume and a wide spread, it is better to refrain from purchasing to avoid additional costs.
4. Trading in the Secondary Market
4.1 Buying and Selling Through a Broker
To start trading bonds, you need to open a brokerage account, fund it, and gain access to the trading terminal. Orders are submitted in the terminal as either a bid (buy) or ask (sell). During times of high volatility, it is advisable to split large orders into smaller portions to smooth the entry or exit price.
To optimize transactions, some traders use algorithmic strategies that automatically divide volumes into multiple orders while considering liquidity in different segments of the order book.
4.2 Assessing Liquidity
In addition to trading volume and spread, assessing liquidity also requires considering the presence of large players and institutional investors. If the bond is actively traded by funds and banks, its liquidity remains stable even during stressful periods.
It is useful to monitor reports from market makers and to track changes in order volumes in the book throughout the trading session to predict liquidity shifts.
5. Taxes and Reinvesting Coupons
5.1 Tax on Coupon Payments
A 13% personal income tax (PIT) is withheld from coupon income for Russian residents. When investing through an Individual Investment Account (IIA), investors can receive a tax refund of up to 52,000 ₽ per year. The account must be open for at least three years.
Some foreign issues are taxed at a rate of 15% or higher. When making direct foreign investments, it is important to familiarize yourself with double taxation agreements and to fill out declarations accurately.
5.2 Reinvesting Coupons
Reinvesting coupon payments can increase overall yield through compound interest. Coupons can be used to purchase more of the same bonds or invested in dividend-generating instruments.
Investors aiming for maximum compounding effect often create a payment schedule and plan reinvestment trades in advance, considering the time of funds crediting and broker fees. This helps minimize drawdowns and effectively grow capital.
6. Selecting Bonds for Beginners
6.1 Selection Criteria
When choosing their first bonds, investors should consider four key parameters:
- Credit Rating: No lower than BBB- for corporate bonds and AAA for OFZ.
- Duration: 2-4 years for moderate interest rate risk.
- Liquidity: Trading volume of at least 100 million ₽ and spread of up to 0.1%.
- Coupon Frequency: Payments at least once every six months for stable cash flow.
To simplify selection, many brokers offer ready-made "portfolios" of bonds based on these parameters. This allows investors to quickly identify the best options for beginners.
6.2 Practical Steps
1. Open a brokerage account with a reliable operator offering low commissions.
2. Study information about selected issuances via the official website of the Central Bank and data from the Moscow Exchange.
3. Create a diversified portfolio of 3-5 issuances, allocating funds across different maturities and issuers.
4. Establish risk management rules: no more than 2% of the deposit in a single transaction and splitting orders for large volumes.
5. Update strategy quarterly, analyzing the impact of macroeconomic events on bond yield and liquidity.
Regular portfolio reviews and adaptation to changing market conditions will help new investors maintain an optimal risk-reward ratio.
7. Advanced Topics and Alternatives
7.1 Bond Investment Funds (ETFs and Mutual Funds)
For those who are not ready to select issues on their own, there are exchange-traded funds (ETFs) and mutual funds focused on bonds. They provide diversification across hundreds of securities and professional management, but charge management fees.
ETFs on OFZ (for example, "FXRB" on the Moscow Exchange) allow investors to buy a share in a basket of government bonds and receive returns close to the market average without the need to calculate YTM themselves.
7.2 "Green" Bonds and Social Bonds
"Green" bonds are issued by companies and government bodies to finance ecological projects. Investors not only receive coupon income but also support sustainable development. Social bonds are aimed at financing social programs such as the construction of schools, hospitals, and affordable housing.
To evaluate such issuances, it is advisable to read the issuer's reports on the targeted use of funds and to check the ESG rating. This enables investors to allocate capital not only for financial returns but also for social and environmental benefits.
7.3 Risks and Pitfalls of Advanced Strategies
Advanced strategies involving leverage (margin lending), yield curve arbitrage, and swaps are associated with high risks. Beginners should avoid credit strategies until they master basic instruments.
Moreover, caution is warranted with offshore issues issued by foreign issuers due to currency risks and complexities with tax compliance across different jurisdictions.
Conclusion
Bonds for beginners offer a blend of straightforward rules, stable income, and moderate risks. By understanding the structure of the instruments, calculating yield, grasping taxation mechanisms, and mastering trading techniques, investors acquire a reliable tool for capital preservation and growth. It is advisable to start with OFZ and bonds from large issuers, gradually expanding the portfolio and mastering more complex strategies as experience is gained.
Frequent portfolio analysis, maintaining a trading journal, and keeping up with market knowledge will help adapt to changing conditions and make informed decisions. A systematic approach and discipline are key factors for success in bond investing.
