Government bonds, fixed rate bonds, premium bonds, floaters, zero bonds - this is how they work

Loans are bonds with a fixed interest rate. Therefore they are also called fixed-interest bonds, obligations, bonds or debentures. Swiss government loans on CHF basis are called Bundesobligationen (government bonds), German government loans are called Bundesschatzbriefe (Federal Treasury notes).

When a loan is taken up, the investor loans a certain amount of money to a company, a bank or a state. This sum is called nominal value. At the same time the issuer (the company, bank or state) commits to pay interest to the creditor according to a fixed interest rate (the nominal interest).

Loans work similar to a bank credit. A term is agreed upon and at the end of this term the issuer must pay the nominal value back to the owner of the loan. Thereby the credit is paid off and the loan has reached the end of its lifecycle.

The term of the loan can vary from less than 4 years to more than 30 years. The nominal interest is usually higher with longer-term investments. That is because the investor here is taking a higher risk and is going without his capital for a longer period of time.

Risk

In contrast to the shareholder, the loan holder is not a co-owner of the company. He is a creditor and the loaned money is outside capital. If the company has to file for bankruptcy, the loan holders are paid off even before the shareholders.

When a state goes bankrupt, it does not look very good for the yield for the government bonds. The state then is officially insolvent and does not pay it's debts back. A violent change of government can also lead to the new government's refusal to service the old regime's debts. Some countries such as Greece are over indebted to such a degree that the state would actually have to declare bankruptcy. National bankruptcies have only rarely been observed in history, in many cases the following governments decided to settle the debts at some point.

But industrial nations in particular are said to be politically and economically stable. Therefore government as well as corporate bonds are said to be less risky than shares.

Besides the issuer's risk, loans have further classifications of risks of the same issuer, as e.g. the different Tier 1 levels. Subordinate additional Tier-1-loans are only serviced after other loan debts are paid back. Besides there are further categories of „Senior Bonds“ which are, for example, additionally collateralized by real estate and other values.

At this time (in 2017) we probably are in the midst of a loan bubble. Government bonds have negative interest. Corporate bonds of low quality (so called junk bonds) do pay good interest, as the „Scholz Bond“ with 8.5%, but the ability of the creditors to pay back is not fully guaranteed.

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Prices and market trends

But the loans have in common with shares that they are traded and their value is indicated by the markets. While shares usually rise during a recovery, the markets of the loans are generally developing very well during recessions.

On the one hand that is because of the fact that the demand for the loans, that are said to be safe, is rising. Shares are thought of by the investors as being too risky. Loans (government bonds in particular) are, in the eyes of many investors, a good way to make it through economically dangerous times.

On the other hand the interest rate level does have influence on the loans. When the interest is low as in a recession, then the investment becomes attractive again because of the fixed interest. When the interest rate level rises, then it makes more sense to leave the money at one's own bank.

In the worst case the interest rises above the regular interest of the loan. The price of the loan thereby will sink below the nominal value. Because the buyer of the loan wants to balance the margin of the interest payments with the margin between price and nominal value. Finally the nominal value gets paid off at the end of the term.




Different kinds of loans

Loans are mainly distinguished according to the investor. As already mentioned above, there are government bonds and corporate bonds. Under Risk the main differences were essentially summed up.

Further loans are distinguished according to the payment terms of their interest. In this sense there are:

  • Fixed-interest Bonds: These loans were described above. They distinguish themselves by a yearly interest rate.
  • Floater: With these loans the interest is determined by the market interest. So the same amount of interest is not paid every year.
  • Structured Bonds: The interest is determined by other factors than the market interest. There are, for example: Zero bonds, inflation-linked bonds etc.
  • Zero Bonds: Are Bundesobligationen (government bonds), that are bought at a low price and have no coupon, so do not distribute interest. These government bonds are bought back at a higher price at the end of the term. The non-distribution of interest can have advantages with regard to taxes, because with it no taxes (dividend tax withholding) are due.

Beyond that, loans can be bundled to a bonds-ETF. Anybody who wants to buy loans, by the way, does not pay in Euro, Pound or Dollar but in percent. By that is meant the percentage of the nominal value, of course.

If one wants to buy government bonds or corporate bonds, one can do that – as with shares – at a broker. On the internet there are many Bond-Finders.