So, what’s a bond?
OK, this isn’t an investment education service. Google is your friend for that, and there are some quick examples here on bonds in general and here on corporate bonds specifically. But for a brief overview…
At its basic level, a bond is issued by an entity (company, country etc) looking to raise money for a period of time in a specific currency.
In return, the usual set up is that the entity looking to raise money will offer to pay a % interest rate each year on a nominal amount (usually a multiple of £100 or something) for a specific time period.
E.g. I offer £100 bond for 5 years at a 2.5% interest rate (known as a ‘coupon rate’).
Thus, I promise, as issuer, to pay 2.5% x £100 = £2.50 each year, for five years, and at the end I’ll give you your £100 back.
Sounds good you think. But how much is the bond actually worth?
This is where the difficulty starts. Whilst we know how much we’ll be getting back at the end of the term (£100) and how much interest we’ll be getting each year (£2.50), the value of that in present day terms can fluctuate day to day, and depends on different people’s perceptions of what fair value is in the market.
There are a few main risks with bonds:
Credit Risk - If the issuer defaults on part, or all of the bond
Interest rate Risk - How do market interest rate changes (or expected changes) affect the price of the bond?
Currency Risk - If the bonds are issued in a foreign currency
Duration Risk - There is much more uncertainty the longer the term of the bond, especially in regards to macroeconomic factors such as inflation (or deflation!)
(As an aside, this article from the excellent Monevator site is well worth a read to understand how interest rate changes affect different duration bonds)
As these risks are dynamic and can change on a daily basis, the price of a bond in the market place can fluctuate. However, it’s coupon rate (the 2.5%) and par value (£100) are fixed.
Given these complexities, there is a clever bit of maths which allows you to take the current market value of a bond and calculate the expected annual return rate you should get if you purchase the bond and hold it to maturity.
This is known as the ‘Yield to Maturity’ of the bond and allows you to compare the expected return on an investment to other opportunities (in financial terms; it won’t help you if the company turns out to be a total fraud for example).
We’ll be highlighting Yield to Maturity when looking at any Bond ETFs during subsequent analysis.
A quick overview of the main risks, as above:
Credit Risk
Essentially this is the risk that the issuer of the bond fails to pay the required coupon (interest rate) on the bond and/or the final maturity payment of the par value.
This is a risk which bond holders attempt to quantify by employing credit ratings agencies who employ many sophisticated computer models to come up with ratings which try and show how much credit risk a borrower has, and therefore how likely the company is to default on its payments.
The top rating is known as ‘AAA’ (hence ‘triple A rated’) or ‘prime’, and goes down to ‘C’ which effectively means good luck getting your money back. Bonds which are at the lower end of the spectrum are known as ‘Junk’ bond, and often have much higher coupon rates to offset the higher risk of default.
It’s worth noting that ratings may only offer a sheen of comfort: many highly rated bonds have defaulted in the past when companies have gotten into trouble (it’s worth reading up about the Sub Prime crash in 2007/08 here, and how some ratings agencies had a very cosy relationship with some of the companies they rated. Michael Lewis is also a good read here - take a look at ‘The Big Short’,).
Interest Rate Risk
This is full of complicated mathematics, but effectively the price of a bond is affected by the trajectory of interest rates set by a combination of central banks and the capital markets.
You should do your own research around this topic as there are many nuances, but the key one is that generally when market interest rates increase, the price of the bond will fall, and vice versa.
Clearly it is difficult for highly paid bank analysts to predict the path of interest rates, let alone your standard retail punter because of the sheet amount of variables affect how rates move over time. These variables will include inflation expectations, demand (or lack thereof) for bonds and currencies in the market place, all the way down to how many times a particular central banker mentions some key words in a speech.
It is also worth noting how sensitive bonds are to rate changes depending on what the prevailing rate is at the time:
For instance, if market rates are at 1%, a move to 2% means rates have doubled, and this will have a greater percentage impact on the bond price than a 1% move from 10% to 11%.
One large positive to bonds, and in particular government issued bonds, is that generally in market crashes/downturns, interest rates fall, which increases the prices of bonds and often provides a ‘cushion’ against the price falls of other assets such as equities.
Currency Risk
This is a more straightforward concept, and similar to other assets such as equities or real estate. If your bonds are denominated in a foreign currency (say US Dollars for UK based investors), then the price of the bond in local currency (e.g. Sterling) terms will vary depending on the prevailing moves in exchange rates.
The other consideration is the interest rate environment in the denominated currency. For instance, US Corporate Bonds issued in Dollars will be influenced by US Dollar interest rates rather than UK interest rates.
One interesting thought point is a bond issued by, say, a Brazilian company in US Dollars.
It might issue a bond in US Dollars for a variety of reasons (larger market place, more dollar based investors etc) but there is some potential additional risk here if the issuing company earns the majority of it’s revenues in the local currency, the Brazilian Real.
The company will need to pay the coupon rate and maturity value in US dollars, regardless of how the Real vs. US Dollar rate moves over time. If the Dollar appreciated greatly against the Real then the company will have to spend more Reals to buy the Dollars required to pay the required value to investors which could prove a challenge to the company - i.e. just because a bond is priced in Dollars or Euros etc does not mean it is necessarily less volatile than one priced in the currency of a smaller sovereign.
This is an example of where multiple risks (in this instance currency and credit) can work in tandem.
Duration Risk
You’ve probably got a fairly good idea of what you are doing tomorrow. Next week is nicely lined up. A year from now less clear but there is most likely a structure in place. Thirty years time? Who knows.
The longer the duration of the bond, the more risk is inherent because the future is unknowable.
Because of this the yields on offer for longer term bonds are generally greater than shorter term bonds (it’s also due to inflation eroding the value of money over time).
Bond Markets are generally divided up by duration:
Less than one year are generally known as Ultra Short Duration Bonds
1-5 Years are Short Duration
5-10 are generally Medium Duration
10-30 are generally Long Duration
30+ is Ultra Long Duration
Perpetual Bonds - like Diamonds - are Forever
This isn’t a strict classification, but what you will find is that shorter duration bonds have lower yields and less price volatility than longer duration bonds.
Some more reading here
Summary
Hopefully this has given a very rough overview of what bonds are, and I recommend additional research as this can be a particularly challenging asset class to gain deeper understanding off due to the large number of variables and mathematical underpinnings.