This chapter is designed to offer a basic understanding of bonds.
Speak to a financial adviser who will be able to recommend investments that are suitable for your individual needs and that best fit your specific risk profile.
What is a bond?
A bond is effectively a loan to a government or corporation.
When you invest in a bond, you are lending money to the organisation that issued it. In return for the investment, the issuer delivers an agreed level of income in the form of a rate of interest (the ‘coupon’).
At an agreed date, the government or corporation will return the face value (the original issue price, see later in this chapter for full definition) of the bond, known as the maturity value.
In many ways, bonds and shares are constantly in competition for investors’ money. When the stock market is falling, investors often turn to the bond market for more stable returns. Investing in the bond market can also be an easy way to add diversification, ultimately reducing the overall risk in a portfolio.
The illustration to the right demonstrates the lifecycle of a bond as if held from the day of issue.
Most bonds can be bought at any time in the secondary market, not just on the day they are issued. The market price of a bond may actually be more or less than its face value. As a consequence, and despite receiving a regular income, the value you receive at maturity may be less than the capital amount invested. Please refer to ‘what are the risks?’ later in this chapter for further details.
Example to show the life cycle of a bond:
Investment in a $1,000 Government Bond with a 5.25% coupon and a three year maturity.
Coupon payment of 5.25% of $1,000 = $52.50.
Coupon payment of 5.25% of $1,000 = $52.50.
On the bond’s maturity day, the year three coupon payment of $52.50 (5.25% of $1,000) and the maturity value ($1,000) are paid out.
You pay a premium to buy the bond and receive a ‘coupon’ (the yearly interest payment) in return, for the duration of the bond. The premium is paid back to you at the maturity of the bond.
High yield bonds
Bonds with a credit rating of BB (Standard & Poor’s)* or Ba (Moody’s)* or below are speculative investments, (see ‘what are the risks?’ later in this chapter for a full explanation of bond ratings). They are called High Yield Bonds or Junk Bonds and are considered to be at a higher risk of default (see later in this chapter), but can potentially offer more growth. Such bonds are typically issued by start-up companies, companies that have had financial problems, or are in a particularly competitive or volatile market, and those featuring aggressive financial and business policies.
A bond issued in a currency other than the currency of the country or market in which it is issued. Eurobonds give issuers the flexibility to choose the currency in which to offer their bond.
Corporate Bonds are debt obligations or IOUs issued by private and public corporations. Companies use the proceeds they raise from selling bonds for a variety of purposes, for example expanding the business.
The Government Bond market is the largest fixed-income market in the UK. The US Treasury Bond market is the largest in the world and is guaranteed by the US Government. In Germany, the Government Bonds are called Bundesrepublik Anleihe, or Bunds, and the French Government issues bonds known as Obligations Assimilables du Trésor (OATs). In the UK, Government Bonds are known as Gilts.
What factors affect the price of bonds?
Interest rates constantly change in response to supply and demand of credit, fiscal policy, exchange rates, economic conditions, market sentiment and changes in expectations about inflation. As these factors change, so do bond prices.
When interest rates rise, new bond issues come to the market with higher yields than older bonds, making the older ones with lower yields less attractive. Hence their price goes down.
The current yield is the rate of return on an investment and is expressed as a percentage. The current yield is calculated by dividing the annual interest payment by the current market value. As the price of a bond declines, its yield rises.
Let’s look at a bond issued with a 4% coupon (the return on an investment). If you were to buy $1,000 worth at launch, you would receive $40 in the first year ($40/$1,000 = 4%). But if the market value of the bond drops to $800, the yield rises to 5%. Why? Because the coupon – $40 – is now 5% of the $800 market value of the bond ($40/$800). If the market value rises to $1,200, the yield will fall to 3.33%.
See calculations below:
This is the value of a bond when it was first issued; the amount printed on the ‘face’ or front of the bond certificate. It represents the amount owed to the investor at maturity. On any day before maturity, the bond’s actual market value may be higher or lower than its face value. When a bond’s market price fluctuates, it has an impact on its yield. If the price drops below the bond’s face value, its yield goes up. If the price rises above face value, the yield goes down.
Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of a currency falls.
The interest rate paid to bondholders is typically fixed at a rate determined on issue. Consequently, if inflation rises, the ‘income’ received from the bond actually becomes worth less in real terms, as goods and services become more expensive.
Inflation is one of the most influential forces on interest rates. Rising inflation often leads to rising interest rates, which would effectively cause a reduction in bond prices. Conversely, deflation would result in a lowering of interest rates, which would increase the price of bonds.
What are the risks?
Whilst bonds have a reputation for being conservative investments, they still have some element of risk in addition to interest rates and inflation expectations.
Credit risk is the potential for loss resulting from a decrease in the financial health of the issuing company. Most corporate bonds are evaluated for credit quality by companies who provide financial market intelligence, such as
Standard & Poor’s and Moody’s Investors Service. Bonds rated BBB or higher by Standard & Poor’s and Baa or higher by Moody’s are widely considered ‘investment grade’.
‘Non-investment grade’ or High Yield or Junk Bonds, those rated BB or lower by Standard & Poor’s or Ba or lower by Moody’s, are deemed to carry a higher ‘default risk’.
Default risk is the risk of non-payment of the bond’s coupon or failure to repay the bond’s face value at maturity. This scenario would usually be as a result of the issuing company getting into financial difficulties or becoming insolvent.
Returns on corporate bonds are generally higher than on Government Bonds. This is because there is a risk of companies becoming insolvent and being unable to repay the bonds or meet coupon payments, whereas governments are less likely to default on their interest payments. In short, corporate bonds pay a higher coupon to reflect the higher risk of these investments, compared with government bonds.
Inflation risk, interest-rate risk and credit risk
Inflation risk, interest-rate risk and credit risk all play a part in the pricing of bonds – the greater the risk, the higher the yield. It’s also true that investors demand higher yields for longer maturities. The reason for this is that the longer the investment term, the higher the risk because given enough time, a once healthy corporation can become insolvent and suddenly lose the ability to pay its obligations. Alternatively, inflation could run rampant, seriously eroding the purchasing power of the amount an investor gets back in future years.
The complexities of yields and credit ratings can easily detract from the key benefits associated with bonds, such as capital growth and a fixed ‘income’ stream. Bond returns are not highly ‘correlated’ with those of shares. In other words, if share prices fall, bonds will not always follow suit and will often rise. For this reason, when combined with other asset classes, they can be a useful diversification tool (read about diversification in chapter 4).
Where the current yield (an estimate of the income return) of a bond fund is greater than the yield to maturity (the total return if all the bonds in a fund were held to maturity), it may signify an erosion of capital. Yields are not guaranteed and may rise and fall.
This chapter sets out the basic characteristics of bonds. It is not designed to be investment advice and should not be interpreted as such. Other factors may need to be taken into account before making an investment decision. Whilst bonds have a reputation for being conservative investments, there are elements of risk that an investor should be aware of in addition to interest rates and inflation expectations.
Note that a bond should not be confused with a ‘portfolio bond’ or ‘collective investment bond’. These are structures (or ‘wrappers’) with a life assurance element, in which multiple savings and investment solutions can be held.