What are bonds? And how do they work?
What are bonds? Bonds are securities that will (usually( pay you a fixed interest % return each year. They are also referred to as Fixed Income assets.
Why would you buy them? Because you want regular consistent income, but you don’t want to take too much risk.
Are they risky? Less risky than stocks, more risky than cash.
Bonds are you lending money to someone else. You give them money, they give you a bond. Bonds usually have a set life, so at the end of their life you get your money back and you get to keep all the interest you’ve been paid along the way.
Bonds are issued by companies (corporate bonds) as well as by governments. US government bonds are known as Treasuries, UK government bonds are known as Gilts.
The amount each bond will pay you in interest is dependent on how secure the person issuing you the bond is.
A very secure and stable issuer (like a government) will pay you a small amount of interest, because your money is very safe with them. A company will need to offer you a higher interest rate to tempt you to buy their bonds, as they’re inherently higher risk than a government. A company could go bust and not be able to afford to pay your interest or give you your money back, whereas a government could technically just print money and pay you (something they often do….).
So remember there are three components to a bond:
You lend money to the issuer (the bond is ‘issued’ and you buy it)
They pay you an interest (coupons)
They give you your money back at the end of the bond’s life (redemption of the bond)
Most bonds are issued with a value (known as ‘par’ value) of $100 or £100. That’s what you’ll pay to buy the bond when it’s issued.
A typical bond looks like this:
Bond issued with par value of £100 and a maturity date 5 years away. This is what you’ll pay to buy each bond.
Coupon rate of 5%, meaning each bond will pay you £5 income per year for the 5 year life.
At the end of the 5 years you’ll get your £100 back.
While the price is £100, you can of course buy more than one.
Your investment return will look like this:
While bonds will always be issued and redeem at par, during the life of the bond the price can trade above or below par based on supply and demand in the market. This will be impacted by many factors, the largest of which is how risky the bond issuer is considered to be.
If bond prices fall you may be able to purchase them for less than par. If you then hold them until maturity, you’ll get the par value back from the issuer, so your return profile will look like this:
Despite the fact that you only paid £90 for the bond, it still pays you a £5 annual coupon, and will still redeem at £100 at the end of its life. So rather than the prior 5% income return, your income yield would have been 5.6%, plus you’d then get an additional £10 on capital gain on redemption.
The opposite can also be true- if bonds trade above their par price your income yield (%) will be lower and you will lose money on the redemption. For example you could buy a bond for £105, still get your £5 coupons (which now equates to 4.76%) and when it redeems you’re only getting £100 back from the issuer so you’d lose £5 in capital.
While that example guarantees you a capital loss if you hold until maturity, it might still be worth doing if the coupons are so high your return still makes sense overall.
Important concepts/terms to know:
Running / income yield: This is your income return on the bond. It is calculated by taking the coupon and dividing it by the price paid. So your running yield varies based on what you pay for the bond.
Eg a £5 coupon if you pay £100 for the bond your running/income yield is 5%, if you pay £95 its 5.3%, if you pay £110 its 4.5%.
Sensitivity to interest rates: bonds are very sensitive to interest rates. As interest rates rise, the return investors can get on risk free assets rises, so they therefore demand higher returns for taking any additional risk. As a result, bond yields need to rise also to ensure investors keep buying them. For the new bonds being issued, they’ll be issued with higher coupons, for those that have already been issued, their prices will fall so that their running yields will rise. So interest rates up, bond yields up also. The same works in the opposite direction.
Always think of bond price and yields like a seesaw. If prices are rising, yields are falling, if prices are falling, yields will be rising.
Yield to maturity: this is your total (return) from the bond: both the income you get (coupons) as well as any uplift / loss you make on the bond itself.
Eg a 1 year bond with a coupon of 5% bought at £96 will have a YTM of 9.4%, because you’ll get 5.2% from income (£5 coupon on your £96 purchase price) and 4.2% from your uplift in the bond value (you paid £96 and you get back £100).
Duration: is how long you ‘get your value back from a bond’. Don’t get duration confused with maturity. Maturity is the life of the bond, maturity is when you get your value back from it. As duration is a time it’s measured in years. If your bond has a low coupon and a maturity way in the future, it will be long duration (many years) because it’s going to take you a long time to get your money back at the low coupon rate and you’ve got to wait a long time for maturity.
On the other hand if a bond has a really high coupon, it’s likely to have a shorter duration because you’re going to get paid your value much sooner.
Another important piece to note on duration is that it also tells you how sensitive a bond is to changes in interest rates. Long duration = highly sensitive (because the changing interest rate will have a lot of time to impact you), if a bond is short duration then you’ll pretty soon have your money back, so interest rate changes won’t matter much to your returns, so your bond price won’t be very sensitive to interest rate changes.