The basics of bonds

Fixed-income investments, or bonds, have traditionally been a ballast for investors’ portfolios, providing income, diversification from stock markets, and capital protection. While low-interest rates have proved disruptive for bonds over the past 15 years, there are signs that they can once again play a more important role in multi-asset portfolios.

With this in mind, it could be time for investors to reacquaint themselves with bonds and how they work. While on the face of it, they are just a loan, this simplicity masks great diversity and nuance underneath.

A bond is, essentially, an agreement between a borrower and a lender. The borrowers are usually institutions like governments and companies, who need the capital to finance projects, or cover day-to-day expenses and many other reasons. Lenders are typically investors like pension funds and endowments, as well as individuals, companies and charities.   The borrowing entity issues a bond to raise money from investors in the ‘primary’ market. A bond will have various key characteristics associated with it:

• The size – amount of money the issuer wishes to borrow
• The term – how long the issuer wishes to borrow for
• The coupon – the regular payment that the borrower makes to the lender

The borrower makes regular coupon payments to the lender over the life of the bond, before also repaying the original amount, or the ‘principal’, at the end of the term.

The coupon will vary depending on prevailing borrowing costs and the riskiness of the borrower.

The types of ‘borrowers’:

Developed market governments – usually regarded as being the safest type of borrower as they receive income from taxpayers and are usually in charge of their own currency, so could potentially create more money to meet their liabilities. Developed market government bonds like US treasury bonds or UK gilts generally have lower coupons compared to similar bonds issued at the same time.

Emerging market governments – these can have more volatile economic and political regimes, so their government bonds can be considered higher risk. To attract investors, they sometimes issue bonds in currencies other than their own, often in US dollars, which introduces a further risk of currency devaluation. Coupons on emerging market bonds are therefore generally higher than developed market government bonds.

Companies – these issue ‘corporate bonds’ which typically have higher coupons than government bonds because they are less creditworthy – companies’ business models can fail, sometimes resulting in bankruptcy and being unable to pay their liabilities. There is a big variation in the financial quality of companies - larger and long-running businesses can typically issue bonds more cheaply than smaller less well-established names.

Credit rating agencies including Moody’s and S&P, help investors consider the creditworthiness of a particular bond issue. They provide a rating for many bonds including high-quality government bonds (usually classified as AAA or AA), and corporate bonds from very large companies which attract similar ratings to governments all the way down the risk spectrum to much more speculative issues. An important distinction exists between bonds which are considered ‘investment grade’ (the top four broad ratings – from AAA to BBB) and ‘high yield’, sometimes unkindly referred to as ‘junk’ bonds, which have much higher risks associated with them. Bond ratings can change over their life according to changes in the creditworthiness of the issuer.

After a bond has been issued it can change hands between different investors in the secondary market – investors can sell a bond before the end of their term, realising the capital early.

The coupon and principal repayments associated with the bond are transferred and paid to the new owner when they are due. Because these are fixed, it is the price of the bond in the secondary market which varies. It changes with prevailing central bank interest rates, supply and demand and changes in the creditworthiness of the issuer. For example, if the central bank increases interest rates, then the price of a bond will typically fall because its fixed coupons become relatively less attractive. If the creditworthiness of the issuer improves because it is making more profit, then the price of its bonds will increase because the probability it will default on its debt has reduced.

We know the return we will get from a bond at the time of purchase, so long as we hold to the maturity date and the issuing institution remains solvent. This return is commonly known as yield-to-maturity (YTM) and is used to compare similar bonds.

The yield-to-maturity equates the present value of all future cash flows (income and capital) to the current market price.  It is the annualised return that an investor will receive if they hold to maturity. It comprises two components: the coupons and the gain (or loss) on the bond’s capital value. The capital component is the difference between the market price of the bond today and its principal repayment value, known as par.

The yield-to-maturity varies based on the current price of the bond, which is driven by supply and demand in the market. If the price falls, then the yield of a bond increases and vice versa.

Duration

Another important concept in bond markets is duration. This is how sensitive a bond’s price is to changes in interest rates. Because a bond with longer to go until it matures has a greater proportion of its cash flows (coupons and principal) still to be paid back to holders, its price is more sensitive to changes in interest rates today. The bond’s price will fall or increase by a greater magnitude than a shorted dated bond when interest rates are increased or cut.

Bond market recent history

During the era of very low interest rates in the decade after the Global Financial Crisis, bond yields fell to record lows. At the lowest point, as much as 40% of the global government bond market had a negative yield.¹ This happens at times of extreme risk aversion, but also when there is a captive buyer. During this period central banks were forced to buy up government bonds regardless of the yield as part of quantitative easing programmes.

This abruptly changed in 2022, as central banks raised interest rates rapidly to curb inflation. Bond yields rose, and prices fell, leaving investors nursing significant losses on their bond portfolios. The UK gilt market, for example, saw price falls of around 24% in 2022¹ as the UK 10-year bond yield moved from under 1% to almost 4%². This price fall would only result in losses for those who sold, however, because investors who hold to maturity would receive their purchase yield to maturity, as long as no defaults occur.

For many years, the role of bonds in a portfolio was relatively straightforward. Investors would use bonds for income, collecting a regular coupon. This was helpful for financial planning where sometimes a predictable income is important. Bonds also provided diversification from stock market investments. Bonds typically provide a ballast against volatile stock markets. That’s because when an economy is facing a downturn, and equity markets usually are performing poorly, central bankers cut interest rates, making fixed coupon bonds relatively more attractive, pushing their prices higher.

However, the period during the financial crisis and beyond has been unusual. Low interest rates saw lower levels of income available from bonds. Equally, high-quality government bonds became more correlated to stock markets, meaning they lost some of their diversifying quality. This worked well for much of the period after 2010 with both bonds and equities doing well. However, it became problematic in 2022 when the interest rate cycle turned and both bonds and equities sold off.

Today, with interest rates higher, bond yields have returned to more normal levels. This means investors can expect to collect a more attractive yield from their bond portfolios once again. Equally, the performance of government bonds and stock markets has diverged, allowing fixed income to resume its previous role as a diversifier in portfolios. Finally fixed income – particularly, high-quality government and corporate bonds – should be able to act as a ‘safe haven’ in portfolios once again, supporting a portfolio amid turbulent equity markets.

In short, it seems it is back to normal for fixed income. Bonds have traditionally played an important role in portfolios, particularly for retirees. After an unusual period, it appears that they can regain their role within portfolios.

Sources:

¹ Sectors A-Z - cumulative performance, Trustnet, trustnet.com [accessed30 June 2023]

² UK 10-Year Gilt, marketwatch.com [accessed 30 June 2023]