What is a bond? How important are bonds?

Stocks and bonds are the most common investment products. Many people have been exposed to stocks, but few people can understand bonds.

When it comes to bonds, there are always a series of question marks: what is a bond, whether it is worth investing, where to buy bonds... Bonds seem far away from us. In fact, bonds are a very basic investment product, which is also very convenient for investment. For most people, investing in bonds is more appropriate than investing in stocks. Why?

This article will introduce you to bonds, bond investment, and the importance of bonds in household asset management (the importance may exceed your imagination).


What is a bond?

Bonds are valuable securities. To put it simply, the issuer borrows money, and the buyer lends money to the issuer. The main issuer of bonds can be the state, local governments, companies, etc.

Bonds have three basic elements: face value, maturity and coupon.

In short, it means how much money to borrow, when to pay, and how much interest.

After the issuance of bonds, the face value, term and coupon will not change.

Investing in bonds, the future cash flow is fixed. In asset allocation, investment products can be roughly divided into two categories: fixed income products (fixed income products) and equity products. The main representative of fixed income products is bonds, and the main representative of equity products is stocks. Compared with stocks, the principal of investment bonds will be safer and the income will be more stable.

Although bond yields are more stable, most people prefer to invest in stocks. Why? They all felt that the bond yield was too low, and the coupon was about 3%. In fact, this is a misunderstanding of bonds. The yield of bonds is not just the coupon.

In addition to coupon, what are the yields of bonds?

What are the yields on bonds?

There are two main components of bond yield: the coupon and the spread.

Coupon is the interest mentioned above. This part of the income is fixed, the amount and time are fixed (proper fixed income).

Spreads are fluctuations in bond prices due to changes in bank interest rates.

When interest rates fall, bond prices rise; conversely, when interest rates rise, bond prices fall.

What are the risks of bonds?

There are many kinds of bond risks, the most important of which are three: default risk, credit risk and interest rate risk.

|Default risk

Default risk is the most serious risk, that is, the bonds cannot repay the principal and interest as agreed. For investors, it is the borrowed money that cannot be collected.

Which bonds are at risk of default?

Here, we should start with the issuing subject. According to the different issuing subjects, bonds can be roughly divided into four categories: national debt, local debt, corporate debt and corporate debt.

National debt, a bond issued by the state, is guaranteed by the state's credit and will not default. (It is said here that China's national debt will not default, and the national debt of other countries still has the risk of default. The largest number of debt defaults in history was Argentina in 2001, with a debt default of 95 billion dollars. In the Argentine debt crisis, debt default was finally resolved through debt relief and extended interest payments.)

Local bonds are bonds issued by local governments, such as those issued by a province or city, with low default risk and slightly lower security than national bonds.

Corporate bonds are bonds issued by listed companies. Risks are related to the company's credit rating. Credit rating is explained below.

Corporate bonds are bonds issued by large enterprises and some central enterprises. Default risk is related to specific projects.

From the perspective of issuers, corporate bonds are mainly at risk of default. In recent years, there have been bond defaults almost every year, and the principal and interest cannot be repaid. There are some famous brands among them.

|Credit risk

The credit risk here refers to the risk of credit rating decline in a narrow sense. (The broad sense of credit risk includes default risk.)

Credit rating refers to the credit rating of a company assessed by a professional rating agency. The more authoritative rating agency representatives are Standard&Poor's and Moody's.

Taking the rating of Standard&Poor's as an example, Standard&Poor's rated the bonds as Grade 4 and Grade 12: AAA, AA, A, BBB, BB, B, CCC, CC, C, DDD, DD, D.

From A to D, the credit rating decreases gradually. To put it simply, Class A bonds are investment grade bonds, basically without default risk; Class B and below bonds are speculative bonds with high default risk; C-rated bonds are high-yield bonds, also known as junk bonds, which are on the verge of default; It is almost hopeless to repay the principal and interest of D-class bonds, which is one step away from closing the door.

Credit risk refers to the risk of declining the bond rating. Some bonds may still be Grade A when you buy them, but the company's business is poor, its profitability is deteriorating, and its solvency is reduced. The most serious case is default, and ultimately it cannot repay the principal and interest.


|Interest rate risk

The interest rate risk is mainly caused by the change of bank interest rate, which will not affect the security of principal. For individual investors, it has little impact, so I won't explain it too much here. Interest rate risk mainly affects a large amount of money of some investment institutions, and of course, investment institutions will also have corresponding measures to deal with interest rate risk. This issue will be explained in more detail later.

The above is the main risk of bonds. As long as the default risk is avoided, the risk of bonds can be almost ignored. There is no default risk in national debt. Investing in national debt can avoid default risk.

How important are bonds in asset allocation?

Bonds are essential in asset allocation, and their importance may exceed your imagination.

How important are bonds?

In terms of the size of the financial market, the scale of bonds in many countries, including China and the United States, is much larger than that of stocks. In China, for example, from 2015 to 2019, the bond market was about twice as large as the stock market. (After 2020, due to the impact of the epidemic, the financial market has been impacted and has not recovered to the normal state of economic development)

From the perspective of asset ratio of institutional investors, the proportion of bonds is basically higher than that of stocks. Taking insurance companies as an example, the CBRC has stipulated that the proportion of bonds in the ratio of insurance assets should not be less than 55%. Why invest in so many bonds? Because the principal of bonds is safe and the yield is stable. Only the continuous and stable cash flow can guarantee the solvency of the insurance company, that is, when the insurance buyer settles a claim, the insurance company has enough money to pay.

The same goes for household asset allocation. Bonds are assets that must be allocated. Why is it so important? The reason is simple. Bonds bring fixed income, which is necessary for everyone. Why does everyone have to? Starting from the actual needs of life, because everyone has a fixed expenditure and everyone needs a safe and stable fixed income, it's as simple as that.

For households, what proportion of bonds should be invested?

This varies from person to person, but there are two general principles for reference.

First, with reference to the proportion of bonds invested by institutions, the proportion of households' bonds should be higher. After all, institutions have more professional investment capacity and more accurate and cautious risk control. It is always more reliable to match with institutions than to take it for granted.

Second, the proportion of bonds should also increase with age, because the older you are, the lower your ability to resist risks, and the more you need safe and stable assets. Imagine a 30-year-old person who lost 200000 yuan in the stock market. He may only lose a few months' salary and can earn back; If 60 year old people lose 200000 yuan in the stock market, their pension life will be greatly reduced, so the older they are, the more they rely on safe and stable assets.

Therefore, in a professional and reasonable asset management scheme, bonds will be allocated. Investment without bonds must be unhealthy and unsafe. No matter how much money you earn from stocks or fixed income products, your assets are still unhealthy and unsafe.

However, from the actual situation, many people are playing with stocks, but their understanding of bonds is very little. Part of the reason is that in the financial media, stocks account for most of the content, and the public lacks channels to understand bonds. Part of the reason is that the public lacks the most basic understanding of asset management.

This may overturn many people's financial cognition, but the fact is that many people are on their way to investing and financing without getting started, including you.