BOND BASICS In this article, we will explain the fundamentals of the bond market, including pricing and interest rates, the risks of investing in bonds, and the traditional role of bonds in an investment portfolio. We will then explore the many sectors of the market, as well as the benefits bonds can provide within an overall investment strategy. Suppose a corporation wants to build a new manufacturing plant for £1 million and decides to issue a bond to help pay for the plant. The corporation might decide to sell 1,000 bonds to investors for £1,000 each. In this case, the ‘face value’ of each bond is £1,000. The corporation—now referred to as the bond ‘issuer’—determines an annual interest rate, known as the ‘coupon’, and a timeframe within which it will repay the principal, or the £1 million. To set the coupon, the issuer takes into account the prevailing interest-rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. Our hypothetical corporation may decide to sell five-year bonds with an annual coupon of 5%. At the end of five years, the bond reaches ‘maturity’ and the corporation repays the £1,000 face value to each bondholder. How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. A £1 million bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years because many factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period. The additional risk incurred by a longer maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk. Every bond also carries some risk that the issuer will ‘default’, or fail to fully repay the loan. Independent credit rating services assess the default risk of most bond issuers and publish credit ratings in major financial newspapers. These ratings not only help investors evaluate risk but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer. A bond’s price always moves in the opposite direction of its yield, as illustrated above. The key to understanding this critical feature of the bond market is to recognise that a bond’s price reflects the value of the income that it provides through its regular coupon interest payments. When prevailing interest rates fall—notably rates on government bonds—older bonds of all types become more valuable because they were sold in a higher interest-rate environment and therefore have higher coupons. Investors holding older bonds can charge a ‘premium’ to sell them in the open market. On the other hand, if interest rates rise, older bonds may become less valuable because their coupons are relatively low, and older bonds therefore trade at a ‘discount’. Put simply, rising interest rates are considered ‘bad’ for bond investors because new bonds will pay investors a higher interest rate than old ones, so old bonds tend to drop in price. Falling interest rates, however, mean that older bonds are paying higher interest rates than new bonds, and therefore older bonds tend to sell at premiums in the market. On a short-term basis, this is true. However, keep in mind the long-term investment picture: as a bondholder, you want to earn the highest yields you can (within your given risk tolerance). Rising interest rates can actually boost a bond portfolio’s return over longer time periods, as the money from maturing bonds is reinvested in bonds with higher yields. Conversely, falling interest rates, while helpful to bondholders in the short term, mean that money from maturing bonds may need to be reinvested in new bonds that pay lower rates, potentially lowering longer-term returns. As you can see from the illustration, duration is less than the maturity. Duration will also be affected by the size of the regular coupon payments and the bond’s face value. For a zero coupon bond, maturity and duration are equal since there are no regular coupon payments and all cash flows occur at maturity. Because of this feature, zero coupon bonds tend to provide the most price movement for a given change in interest rates, which can make zero coupon bonds attractive to investors expecting a decline in rates. Variations on a Theme: The Many Different Kinds of Bonds In the 1970s, the bond market began to evolve as investors learned there was money to be made by trading bonds in the open market. As investor interest in bonds grew (and faster computers made bond math easier), finance professionals created innovative ways for borrowers to tap the bond market for funds and new ways for investors to tailor their exposure to risk and return potential. • Agency and ‘Quasi-Government’ Bonds: Central governments pursue various goals—supporting affordable housing or the development of small businesses, for example—through agencies, a number of which issue bonds to support their operations. Some agency bonds are guaranteed by the central government while others are not. For example, the German government guarantees bonds issued by the agency KfW, which makes housing and small businesses loans. On the other hand, the U.S. government does not guarantee bonds issued by agencies Fannie Mae and Freddie Mac, both of which buy mortgages from banks, but does guarantee bonds issued by Ginnie Mae, another mortgage agency. Supranational organizations, like the World Bank and the European Investment Bank also borrow in the bond market to finance public projects and/or development. |
• Emerging Market Bonds: Emerging market bonds are sovereign bonds issued by countries with developing economies, including most of Africa, Eastern Europe, Latin America, Russia, the Middle East and Asia excluding Japan. The emerging market sector has grown and matured significantly in recent years, attracting many new investors. While emerging market bonds can offer very attractive yields, they also pose special risks, including but not limited to currency fluctuation and political risk. An emerging market portfolio would usually be more volatile than that of a U.S.-only portfolio. • Local Government Bonds: Local governments borrow to finance a variety of projects, from bridges to schools, as well as general operations. The market for local government bonds is well established in the U.S., where these bonds are known as ‘municipal bonds’, and European local government bond issuance has grown significantly in recent years. In the U.S., municipal bonds (munis) may enjoy a tax advantage over other bonds because interest on municipal bonds is exempt from federal taxes. However, capital gains on U.S. munis are not tax exempt and income from portfolios that invest in munis is subject to state and local taxes and, possibly, the alternative minimum tax. Corporate Bonds Corporate bonds fall into two broad categories: investment-grade and speculative-grade (also known as high-yield or ‘junk’) bonds. Speculative-grade bonds are issued by companies perceived to have a lower level of credit quality and higher default risk compared to more highly rated, investment-grade, companies. Within these two broad categories, corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly (see table). Speculative-grade bonds tend to be issued by newer companies, companies that are in a particularly competitive or volatile sector, or companies with troubling fundamentals. While a speculative-grade credit rating indicates a higher default probability, higher coupons on these bonds often compensate for the higher risk. Ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve. Derivatives carry their own distinct risks and portfolios investing in derivatives could potentially lose more than the principal amount invested. Derivatives may involve certain costs and risks such as liquidity risk, interest rate risk, market risk, credit risk, management risk and the risk that a portfolio could not close out a position when it would be most advantageous to do so. Mortgage-Backed and Asset-Backed Securities • Mortgage-Backed Securities: These bonds are securities created from the monthly mortgage payments of many residential homeowners. Mortgage lenders sell individual mortgage loans to another entity that bundles those loans into a security that pays an interest rate similar to the mortgage rate being paid by the homeowners. As with other bonds, mortgage-backed securities may be sensitive to changes in prevailing interest rates and could decline in value when interest rates rise. And while most mortgage-backed securities are backed by a private guarantor, there is no assurance that the private guarantors or insurers will meet their obligations. • Asset-Backed Securities: These bonds are securities created from car payments, credit card payments or other loans. As with mortgage-backed securities, similar loans are bundled together and packaged as a security that is then sold to investors. Special entities are created to administer asset- backed securities, allowing credit card companies and other lenders to move loans off of their balance sheet. Asset-backed securities are usually ‘tranched’, meaning that loans are bundled together into high-quality and lower-quality classes of securities. • Pfandbriefe and Covered Bonds: German securities secured by mortgages are known as Pfandbriefe or, depending on the size of the offering, ‘Jumbo’ Pfandbriefe. The Jumbo Pfandbrief market is one of the largest sectors of the European bond market. The key difference between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make loans and package them into Pfandbriefe keep those loans on their books. Because of this feature, Pfandbriefe are sometimes classified as corporate bonds. Other nations in Europe are increasingly issuing Pfandbrief-like securities known as covered bonds. The non-government bonds described above tend to be priced relative to a rate with little or no risk, rates such as government bond yields or the London Interbank Offered Rate (LIBOR). The difference between the yield on a lower-rated bond and the government or LIBOR rate is known as the ‘credit spread’. Credit spreads adjust based on investor perceptions of credit quality and economic growth, as well as investor demand for risk and higher returns. Another active bond investment strategy is to adjust the credit quality of the portfolio. For example, when economic growth is accelerating, an active manager might add bonds with lower credit quality in hopes that the bond issuers will experience credit improvement with the positive change in the economy and the bond prices will rise. In some cases, active managers take advantage of strong credit analysis capabilities to identify sectors of the market that seem likely to improve, therein potentially increasing a portfolio’s return. A third active bond strategy is to adjust the maturity structure of the portfolio based on expected changes in the relationship between bonds with different maturities, a relationship illustrated by the ‘yield curve’. While yields normally rise with maturity, this relationship can change, creating opportunities for active bond managers to position a portfolio in the area of the yield curve that is likely to perform the best in a given economic environment. |