Written by Dimitry Griko, CIO fixed income at EG Capital Advisors.
In this first part of his Myth-Busting Bonds series, Dimitry Griko covers the four things you need to know to get started.
A bond is in effect a standardised loan issued by a government or company that needs to raise money. It usually comes with a set interest rate (known as the yield or coupon) and timespan (known as the maturity), at which point the original sum lent (known as the principal) is returned to the bond holder. Bonds are also known as fixed income or fixed interest instruments.
Although the world of bonds is a complex area, the following four facts should act as a useful starting point.
Bond holders are compensated for risk
Anyone who lends money wants to be compensated for the risk that they won’t be paid back (known as a default). As a result, the yields are higher on bonds that are perceived as higher risk.
There are two main factors that determine the yield of a bond: credit quality and time to maturity. The bonds with the highest credit quality and therefore the lowest risk of default are referred to as investment grade and will carry a lower yield; those with a lower credit quality and a higher risk of default are referred to as high yield or even “junk” bonds.
Generally, the longer the period until a bond matures, the higher the yield. This is compensation for greater uncertainty, as while it may be safe to assume little will change for a government, company or the macroeconomic environment in which they operate over the next three months, it would be difficult to make that assertion with any degree of confidence over a period of 10 years.
Government bonds of developed countries were traditionally considered safer
The US has never defaulted – if you ignore the technicality of 1979 when a government shutdown and a failure of word processing equipment led to a delay in payments to creditors. The UK government hasn’t either, although England suspended debt payments in 1672 under Charles II.
This is why government bonds are sometimes regarded as the safest assets – remember, the Financial Services Compensation Scheme only guarantees £85,000 per person, per bank, building society or credit union.
Yet this does not mean that government bonds are completely safe, with Argentina and Greece among the countries that have had to “restructure” their debt in the past decade. And, although you won’t lose money in absolute terms if you hold a bond to maturity, the value of your money will decline in real terms if the rate of inflation moves above that of the yield.
Bonds are tradeable
You do not have to hold a bond to maturity and can trade most types of these instruments with other buyers. There are many reasons why you may wish to do this – an insurer may need capital to pay out on its policies and may be able to sell some of its holdings to a competitor who has experienced an increase in business.
However, many fund managers and traders aim to make money from buying and selling bonds by exploiting inefficiencies in their price. After analysing a bond, for example, a fund manager may
decide it is at less risk of default than its high yield suggests. Therefore, they may decide to either buy the bond and take the higher yield or wait until the market catches up with their way of thinking and sell it for a profit.
Bond prices and yields have an inverse relationship
When the yield of a bond goes up, its price goes down, and vice versa. This initially sounds counterintuitive – after all, shouldn’t an asset that pays you more also be worth more? However, it makes perfect sense.
Imagine you buy a bond issued by an oil-exploration company just after the market opens. The company has yet to strike oil, so it risks running out of cash. As a result, anyone who lends it money wants to be compensated for the risk of default, so it offers a high yield of 10 per cent on its 10-year bonds. Now, imagine you have a stroke of luck – 10 minutes after you buy its bond, the company announces it has struck oil. Because the risk that the company will fail to pay back its debt has vastly diminished, it doesn’t need to offer such a high yield on any new bonds it issues – to keep things simple, let’s say they now only pay 5 per cent. Now you hold a security which pays previously set 10% instead of the fair market 5%, obviously people will pay up for it.
This helps to explain why bond prices also have an inverse relationship with interest rates. The sensitivity of a bond to interest rates is known as duration risk.