Bond 101 - Understanding the Opportunity in Fixed Income
By Nic Spicer - November 30, 2022
Towards the end of a difficult year for investors, we’ve been asked by advisers if we’re seeing any green shoots anywhere. Where’s the good news for clients? Is there any light at the end of the tunnel? When it comes to equities, the best we can say is that they are much more reasonably priced now than they were at the beginning of the year and are, on the whole, good value on a long-term view. How they will perform in the near term remains uncertain.
But, equities are not the only investments out there. Bonds are the second major asset class for retail investors, and there, the news is much more positive. Falling prices year to date have left fixed-income sub-asset classes with yields close to their highest levels in over 10 years (see chart below).
Unlike equities, bonds tend to perform better in a recessionary environment because recessions throttle inflation as well as equity returns, and falling inflation allows central banks to cut interest rates which boosts bond prices.
Bonds aren’t, however, the easiest asset class to get one’s mind around. So, we thought we’d go back to basics and produce a simple Q&A on bonds that can be used in adviser discussions with clients.
What is a bond?
A bond is a tradeable debt security. There are other types of debt security, but bonds are those issued by a government, company or other organisation (the borrower) which in exchange for the amount borrowed (principal) agrees to pay the purchaser (the lender) a regular interest payment called a coupon and the principle back at the maturity of the bond.
The asset class is known as 'fixed income' because the coupon paid is fixed at the outset.
What is the “yield” on a bond?
The yield on a bond is the effective percentage annual return earned on the bond if you hold it to maturity i.e. you hold it until it’s repaid. For example, a bond issued at $100, paying $4 each year and redeemed at $100 in 10 years has a yield of 4%.
Crucially, you can be certain that you will earn exactly the yield on a bond if you hold it to maturity and it doesn’t default. Bond prices may fluctuate during the life of the bond but they always revert back to 100 just before they are repaid.
How safe are bonds?
Your bond will get repaid unless the issuer defaults. The chance of a bond defaulting is dependent on who issued the bond and more specifically on their willingness and ability to repay their debt.
Credit rating agencies like Standard & Poors, Moody’s and Fitch rate how strong issuers are with the stronger issuers rated ‘investment grade’ and lower quality issuers rated ‘sub-investment grade’. Weaker issuers with lower credit ratings pay higher yields and so sub-investment grade bonds are often referred to as ‘high yield’ bonds.
Investment grade bonds almost never default, but high-yield bonds can also be attractive investments if enough different high-yield bonds are held in a portfolio. This is because their higher yields more than compensate for the odd default by one or two bonds in the portfolio.
As a general rule, bonds are safer than equities. Governments are the biggest issuers of bonds (and they have more resources to repay than companies), but even when issued by a company, bonds are safer than equities because if a company runs into trouble its bondholders get repaid before equity holders get paid anything.
Higher quality bonds’ fixed income characteristics also make them attractive in a recession – a fixed payment (that doesn’t go down) becomes more attractive when other asset classes are uncertain.
How are bond yields and bond prices related?
Bond yields and bond prices move in opposite directions. The lower the bond price, the higher the yield (and vice versa). In the example above, a bond issued at $100, paying $4 each year and redeemed at $100 in 10 years has a yield of 4%. If the bond price falls to less than 100, then anyone who holds the bond can now expect a higher return than 4% (they’ll still get the $4 coupons, but they’ll also make money when the bond is redeemed at $100, more than they bought it for).
This is what is happening when the US Central Bank says it’s going to raise rates more aggressively than markets expected (and markets believe them), then investors require a HIGHER yield on US bonds which causes bond prices to then FALL to deliver those higher yields going forward.
The process works in reverse too: LOWER bond yields imply and are implied by bond price RISES.
What is “duration”?
Bond duration is a measure of how sensitive a bond’s price is to interest rates (i.e. how much its price rises or falls when interest rates change). The exact calculation is quite complicated, but as a rule of thumb, a bond’s duration is roughly how many percent its price falls when interest rates go up by 1% (or how many percent it goes up when interest rates fall by 1%).
So, the price of a bond with a duration of 8 will fall by roughly 8% if interest rates go up by 1%.
Duration is very much linked to how long remains until a bond matures (gets repaid). Longer maturity bonds (bonds with more time until they are repaid) have higher or longer durations and are MORE sensitive to changes in interest rates. Shorter maturity bonds (bonds with less time until they are repaid) have lower durations and are LESS sensitive to interest rate changes.
Do Central Bank Rate Rises Cause Bonds Prices to Fall?
Not necessarily. Bond yields (and hence prices) are determined by expectations of future rate rises. So what matters is not whether a central bank raises or lowers interest rates, but whether it does so more or less than is already expected.
For example, if the US Federal Reserve raises rates by the biggest amount in 20 years, but this is what markets were already expecting, then bond prices won’t fall. Bonds were already pricing in this rate rise so they don’t need to fall further. In fact, if there is a giant rate rise, but markets were expecting an even bigger one, this would be treated as a positive surprise and bond prices would actually rise.
Likewise, central banks can cause bond prices to move just by talking about what they plan to do in future. Even if they don’t raise or lower rates at that point in time, they can change expectations about future rate rises, and so affect bond prices.
Central banks are currently expected to raise rates aggressively but this is reflected in current low bond prices.
Can you lose money investing in bonds?
There are only three ways to lose money investing in a bond:
Overpaying: The investor pays so much for the bond that it has a negative yield at purchase. Holding to maturity then guarantees a loss
Selling at a bad time: The investor sells the bond before maturity at a loss
Default: The bond defaults (the issuer fails to repay the bond)
(I’ve ignored the potential for loss if you invest in a foreign currency bond as this can be dealt with via hedging out the risk. I’ve also ignored any loss of purchasing power due to high inflation as this isn’t a loss in nominal terms)
So, why do bonds look attractive at present?
Very simply, bonds are currently offering very attractive yields (bond prices are low) and investors can quite easily realise these attractive yields by:
Holding their bonds to maturity (it is sensible to choose a mix of shorter and longer maturity bonds to invest in so they don’t have to sell out at a loss)
Protecting against defaults by selecting investment-grade bonds and/or a highly diversified assortment of high-yield bonds with high enough yields to compensate for any potential defaults.
For lower and mid-risk portfolios, PortfolioMetrix is invested in just this way to realise the attractive returns of the asset class: a mix of shorter and longer maturity bonds; both investment grade and higher yield bonds, with, as always, plenty of diversification.
PortfolioMetrix is a global investment manager operating in the United Kingdom, South Africa, and Ireland. We support independent advisers to scale sustainably without compromising the quality of advice they provide to their clients. Our risk-based investment process ensures carefully calibrated portfolios that deliver predictable outcomes specific to each investor. Our technology, WealthExplorer™ allows the adviser to extract the synergies between financial advice and investment management, providing deeper client insights and more robust recommendations. If you have any questions or would like to learn more, please contact us here.