What are bonds?
Introduction
Fixed income is an asset class that is a commonly held investment because it helps preserve capital. Fixed-income investments, or bonds as they are commonly known, typically provide a premium above inflation and experience less return volatility compared with shares.
Fixed income is held for the steady income stream the regular coupon payments provide.
Bonds can offer diversification benefits because they often perform in the opposite direction to shares. Bond investments, therefore, help to lower the risk level within a diversified portfolio.
What are bonds?
One way a government or a company can obtain the money they need to fund their projects or initiatives is to sell bonds.
In other words, a bond is a loan sold or issued by the borrower (issuer) and purchased by the lender (investor). The borrower in turn makes two key promises to the lender:
- To repay capital at maturity – the loan will be repaid on a predetermined date
- To pay regular interest payments at a rate known as the coupon rate. This forms the interest on the borrowed amount paid to the investor during the life of the loan
What determines the level of coupons to pay? There are a few factors to consider:
- Economic conditions: The higher the expectation of economic growth and inflation, the higher the interest rate/return expectation.
- Investment timeframe: The longer the maturity, the higher the interest rate. In general, the longer the period of time investors have to give up the use of their money, the higher the interest rate they will want.
- Risk premium: The higher the credit risk of an issuer, the higher the interest rate. This is because investors need to be compensated for the amount of risk they are taking.
The following are some commonly used terms that may be useful when talking about bonds. (We will explain elsewhere what yield means.)
| Term | Explanation | Example |
|---|---|---|
| Face Value | The initial loan amount | $500,000 |
| Coupon | A set level of interest paid per face value | 5% p.a. |
| Yield | The annualised return a bond offers at its current price | With a 5% coupon rate, if the current bond price < 100, yield > 5% If current bond price > 100, yield < 5% |
| Maturity | The pre-determined date of loan repayment | 10 years from now |
The mechanics of bonds
How do bonds make money for you?
Bonds (with the exception of zero coupon bonds discussed below) pay out a regular stream of interest known as coupon payments. There are several ways the bond issuer can go about this, depending on the type of bond. Below are some examples:
- Fixed-rate bond - a bond with a fixed coupon rate.
- Floating rate bond - a bond with a variable coupon, usually tied to a reference interest rate like Bank Bill Swap Reference Rate (BBSW), for example.
- Zero coupon bond - a bond that pays no interest during the life of the bond, but is instead sold at a deep discount from its value at maturity.
However, coupons are just part of the total returns that investors can receive when investing in bonds. The other source of return is capital gain. Bonds, like stocks, are subject to market conditions and their value can fluctuate (or move up and down) from the time they are issued until their maturity. Factors affecting the price of a bond during its life are discussed later.
The relationship between yield and price
The price of a bond can fluctuate throughout its life. This fluctuation is in response to the current interest rate environment. Since bonds cannot change their coupon rates to align with current interest rates, their prices will adjust accordingly so that their yields can do so.
What is yield?
Put simply, it is a measure of return available from a bond. Take the example of a 10 year bond with a par value of $100, which pays out a 5% coupon rate (i.e. $5) each year. The yield on the bond is therefore 5%.
Suppose interest rates in the market increase to 6%. Because the coupon rate on the bond is already fixed, the price of the bond will have to drop proportionately so that the return from the bond (i.e. the yield) increases to 6%. In other words, the price of the bond will drop to about $83 so that the yield on the bond will increase to 6% ($5 / $83), in line with prevailing interest rates. This way, the bond will not be any less attractive than any other investments in the market.
Conversely, should prevailing interest rates drop to 4%, the price of the bond will increase to about $125 so that the yield on the bond will decrease to 4% ($5/$125)
Therefore, the price of a bond is inversely related to its yield.
A term that is commonly used is the yield-to-maturity (usually abbreviated to YTM). YTM is a useful measure, especially when comparing bonds of different coupons and maturities. It assumes that any coupons received from the bond are reinvested at a rate equal to the YTM. The calculation for YTM is based on the coupon rate and length of time to maturity, as well as the market price.
What is duration and how is it used?
So far, we have seen how bond prices move in relation to interest rates. However, how can we know how much a bond’s price will change in response to a move in interest rates?
This is where duration comes in. Duration expresses the sensitivity of a bond’s price to changes in interest rates and tells us the approximate change in the price of a bond in the event of a 1% change in interest rates. Duration is stated in years. For example, a two-year duration means that the bond will decrease in value by 2% if interest rates rise by 1% and increase in value by 2% if interest rates fall by 1%.
As the table below shows, bond prices are impacted by interest rate changes - bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations.
| Bond A | Bond B | Bond C | Bond D | |
|---|---|---|---|---|
| Term to maturity (years) | 5 | 10 | 10 | 10 |
| Coupon | 5% | 5% | 8% | 8% |
| Yield | 5% | 5% | 5% | 10% |
| Duration (years) | 4.55 | 8.11 | 7.54 | 7.04 |
| Price change for 1% rise in rates | -4.55% | -8.11% | -7.54% | -7.04% |
| Price change for 1% fall in rates | +4.55% | +8.11% | +7.54% | +7.04% |
In other words, duration can be an indicator of how risky a bond is. For example, if you are not risk averse and think that interest rates are going down, you should buy a bond with a longer duration, so that you will benefit more from a fall in interest rates compared to a shorter duration bond. Conversely, should your view be wrong and interest rates increase instead, you would suffer a greater loss.
Bond yield and time to maturity
The yield curve is the relationship between the interest rate and the time to maturity of the debt for a given borrower in a given currency.
Generally speaking, yield curves can be broadly classified into three main types.
- Normal yield curve – Yield curves are usually upward sloping, meaning the longer the maturity, the higher the return (yield). A longer-term bond usually involves more risk that the borrower will default, or interest rates will change, or the lender will find a better potential use for their money. Investors therefore demand greater compensation for the uncertainty over a longer time period, also known as term premium.
- Inverted yield curve – An inverted yield curve arises when short term interest rates are high relative to long-term expectations. This curve indicates that investors expect interest rates to be lower in the future. Term premium in this instance is negative.
- Flat yield curve - This curve indicates the yields of bonds with different maturities are relatively constant, and is seen when interest rates are expected to decline moderately but offset by positive term premium.
Credit rating and risk
Rating agencies
A credit rating agency is an independent rating agency that analyses and publishes a credit rating on companies and governments which issue bonds. These rating agencies periodically review their ratings and occasionally move them higher or lower. When a rating change occurs it is normal for the outstanding bonds affected to increase in value (in an upgrade) or decrease in value (in a downgrade). Common rating agencies include Moody’s, Standard & Poors and Fitch, and rating decisions are based on factors such as:
- Background and history of the company
- Corporate strategy and philosophy
- Analysis of business risks
- Analysis of the company's financial risks
- Analysis of the management team
| Credit risk | Moody's | Standard & Poor's |
|---|---|---|
| Investment grade (High grade) | ||
| Highest quality | Aaa | AAA |
| High quality (very strong) | Aa | AA |
| Upper medium grade (strong) | A | A |
| Medium grade | Baa | BBB |
| Non-investment grade (High yield) | ||
| Lower medium grade (somewhat speculative) | Ba | BB |
| Low grade (speculative) | B | B |
| Poor quality (may default) | Caa | CCC |
| Most speculative | Ca | CC |
| No interest being paid or bankruptcy petition flied | C | C |
| In default | D | D |
Put simply, a rating assigned to a bond issuer can be a guide to the question: "When I lend my money to this company today, what is the possibility that I will not get my money back?"
Each credit agency has its own grading system. Standard & Poor’s grading system, for example, ranges from AAA (highest quality) to D (in default). Ratings of AAA, AA, A and BBB are considered investment grade (or high grade), while any rating below BBB is considered non-investment grade (high yield).
Risks involved in bond investing
There are a number of risk factors that affect bond investing, most of which are interrelated.
Interest rate/duration risk –As previously mentioned, bond investments are sensitive to the movements in domestic and international interest rates (or yield), and the magnitude of this risk is measured by duration. The level of duration is therefore an important aspect to consider when investing in a bond or a portfolio of bonds.
Credit/default risks– The possibility that a bond issuer will default means that the issuer will be unable to make interest or principal payments when they are due. Bonds issued by government or government agencies or government-sponsored enterprises, in the majority, are less likely to suffer from default due to their ability to raise taxes. In comparison, bonds issued by corporations, particularly high yield bonds, have a higher probability of default.
Liquidity risk– There is a probability of loss arising from the difficulty of selling an asset because of insufficient buyers or sellers in the open market. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Liquidity risk may be quantified as the difference between an asset's value and the price at which it can likely be sold. To manage liquidity risk, investors can consider investing in higher quality assets, such as investment grade bonds.
Types of bonds
Types of bonds issued today
Now that you're more familiar with bond terms and features, we're going to discuss some of the different types of bonds issued today. Bonds come in all shapes and sizes, and indeed the investment universe for this asset class is large and diverse. Common types of bonds are described below:
- Government bonds- These are bonds issued by a national government, denominated in the country's own currency, for example Australian Commonwealth Government Bonds and US Treasuries. Government bonds are usually referred to as risk-free bonds with very low default risk and are among the safest investments, because the government can raise taxes or print money to redeem the bond at maturity. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds.
- Semi-government bonds- These are bonds issued by state or local governments and are issued to fund infrastructure projects and other ongoing financial commitments. Examples include bonds issued by New South Wales Treasury and Queensland Treasury Corporation. Semi-Government bonds often have higher yields than government bonds to compensate investors for the additional credit risk taken.
- Supranational bonds- Supranational debt refers to bonds issued by international organisations, often multinational or quasi-government organisations, with a purpose of promoting economic development. Examples include World Bank and Asian Development Bank, and debt issued by these entities into the Australian market is often referred to as Kangaroo bonds. Similar to semi-government bonds, these often have a higher yield than government bonds.
- Corporate bonds- These are bonds issued by companies to raise money for business purposes, e.g. to expand operations or fund new business ventures. Corporate bonds usually pay higher rates than government bonds, because they tend to be riskier. Corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly. (Please refer to the rating agency section). High yield bonds are issued by lower quality corporates and therefore have higher yields to compensate for the additional default risk.
- Hybrids- These are securities which have characteristics which are equity-like (e.g. perpetuity) and bond-like (e.g. regular coupon payments). Given the nature of these investments, they typically provide higher yields but also have higher risk associated.
- Emerging market bonds– These refer to bonds issued by governments and companies in developing markets such as Latin America, Russia, the Middle East and Asia excluding Japan. Emerging market bonds usually offer very attractive yields and pose special risks such as political and institutional instability and currency volatility. Again, because of the higher risk involved, their yields are generally higher.
- Inflation linked bonds- The interest rate on these bonds are adjusted on a regular basis to reflect changes in the rate of inflation, thereby providing a real or inflation-adjusted return. Inflation linked bonds could experience greater losses when real interest rates are rising faster than normal interest rates. Inflation linked bonds are usually issued by the federal government.
- Mortgage-Backed Securities (MBS)- These are bond securities are created from monthly mortgage payments. 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. MBS, like all other bonds, are sensitive to changes in prevailing interest rates and could decline in value when interest rates rise.
- Asset-backed securities- These are bonds created from car payments, credit card payments or other loans. This kind of loan is bundled together and packaged as a security sold to investors. Asset-backed securities are usually “tranched”, which means that loans are bundled together into high-quality and lower-quality classes of securities.
Different bonds are suitable in different economic cycles
Regardless of which point of the economic cycle we are currently at, there are always opportunities for bond fund managers to make money from the asset class. This is because different types of bonds perform differently at different points of the economic cycle.
For example, during a period of economic downturn, government bonds tend to outperform as risk aversion increases and interest rates fall. On the other hand, during a period of economic recovery, corporates (particularly high yield bonds) would tend to outperform as credit conditions improve.
Trading bonds
Advantages of bond funds
A purchase of a single bond typically needs a much higher entrance threshold, e.g. A$500,000. The minimum investment amount varies depending on the type of bonds and the respective market prices at the point of trading. A selection of bonds with lower entrance thresholds than this example are available to retail investors, but the breadth of bond investments is far greater in the institutional market.
A bond fund offers a much more convenient and affordable way to invest, with thresholds as low as A$25,000 (which is the minimum direct investment to the Schroder Fixed Income Fund, for example) and provides access to a diversified portfolio of bonds.
Investing directly in bonds versus through bond funds
Having explained the technicalities of how a bond works, it is not hard to see why bonds can be attractive investments. Besides diversification, they also offer higher potential returns over cash deposit rates, but without the volatility of shares.
The easiest way to get started is to invest in a bond fund rather than investing directly. Here are the reasons:
Diversification
As the old adage goes, do not put all your eggs into one basket. As the past has shown, even big global names can default on their loans or even go bankrupt. This is why investing in a portfolio of bonds, researched and picked by a fund manager, ensures proper diversification across regions, sectors and companies.
High investment amount
A purchase of a single bond typically needs a much higher entrance threshold, e.g. A$500,000*. A bond fund offers a much more convenient and affordable way to invest, with thresholds as low as A$25,000^ and provides access to a diversified portfolio of bonds.
*the minimum investment amount varies depending on the type of bonds and the respective market prices at the point of trading. A selection of bonds with lower entrance thresholds than the stated amount are available to retail investors, but the breadth of bond investments is far greater in the institutional market. ^ minimum direct investment to the Schroder Fixed Income Fund
Liquidity
Given the high investment amount, it may be difficult at times for you to sell off your bond to another investor. Investing in a bond fund, however, means that you can redeem your units at anytime (subject to the terms and conditions set out in the relevant offering documents).
Professionally managed with bond allocation and duration
Apart from the convenience of investing in bond funds, when it comes to buying bond funds, a professional manager backed by a strong global research team and credit analysis capabilities to identify potential sectors can help investors maximise the return on a bond portfolio. Active bond managers commonly adjust a bond portfolio’s duration (the weighted average duration of all the bonds in the portfolio) and adjust the credit quality based on expectations of economic growth and credit conditions.
Fixed income at Schroders
Schroders' approach to fixed income
At Schroders, we believe the fixed income universe is extremely diverse. This breadth, and the diversity of possible risk and return outcomes, means active management is essential. Schroders employs a top down approach to managing bonds and aims to add value through four levers:
- Asset allocation– determine the right asset class of bonds (e.g. government bonds, corporate bonds etc.) to own based on our economic and return forecasts as this is the most important driver of return over time. The investment decisions also extend to geography (e.g. Australia vs. US) and industries (e.g. financials vs. utilities).
- Interest rate management– actively manage the level of interest rate (or duration) risk at various points of the economic cycle to generate returns based on interest rate expectations. For example, the fund manager aims to lower duration in a rising interest rate environment and to raise duration in a falling interest rate environment.
- Security selection– capitalising on Schroders’ research capabilities to generate returns from investing in bonds at acceptable risk. Specifically, we aim to identify and avoid investing in bonds where the risk of default is material but is not reflected in the price.
- Risk management– ensure the portfolio of bonds is sufficiently diversified and risks associated, particularly downside risks (i.e. risk of negative returns), are appropriately managed.
Why Schroders for bonds?
- Focus– our core business is asset management. Our goal is to build a first class asset management business and deliver the best investment capabilities to our clients.
- A global business- Schroders is a global asset management company with A$1,365.8 billion under management and 600+ investment professionals operating in 38 offices around the world (as of 30 December 2022). Globally, we currently manage A$262.88 billion in fixed income assets (as of 30 June 2022). Schroders' Australian fixed income business manages a total of A$6.2 billion (as of 30 December 2022).
- Experience- our highly experienced Australian fixed income team is led by Stuart Dear, Head of Fixed Income. The local fixed income business has been running for 20 years, and the team members' average industry experience is 15 years.
- Deep resources- the team is well integrated into the wider Schroders global fixed income team, comprising over 300 investment professionals, and can also leverage resources worldwide across different asset classes, providing truly diverse global coverage on investment ideas, research and implementation platform in key regions and asset classes.
- Accountability– the Australian Fixed Income team has clear ownership and accountability for meeting client objectives.
- Research commitment- we have a strong belief that independent analysis drives results. Our fixed income research covers broad market strategic views, including economic forecasts and fundamental bottom up credit research, reviewing over 1,000 bond issuers each year.
- Risk management -our focus on managing risk, especially downside risk, ensures we allocate risk effectively, which is vital to investors in defensive assets.
The information contained in this material is general information only and does not take into account your objectives, financial situation or needs. Before acting on the information contained in this material you should consider the appropriateness of the information in regard to your objective, financial situation and needs before making any decision about whether to invest, or to continue to hold an investment.
The repayment of capital and performance of an investment is not guaranteed by Schroders or any other party. Opinions constitute our judgement at the time of issue and are subject to change. Past performance is not an indicator of future performance. Investment guidelines represented are internal only and are subject to change without notice. Schroders may record and monitor telephone calls for security, training and compliance purposes.
Quiz
Q:You purchase a A$500,000, ten-year bond with a coupon rate of 5%. What will your interest payments be each year?
A:The coupon rate is 5%, which means you receive A$25,000 each year (5% of A$500,000).
Q:You own a 6% bond and want to sell it in a year. Do you hope that interest rates rise or fall?
A:You hope that interest rates fall. When interest rates fall, newly issued bonds will likely offer a lower interest rate. So your bond paying 6% will be more appealing to investors and thus command a high price.
Q:You buy a bond and intend to hold it to maturity. Is the bond’s changing price and yield a concern to you?
A:No, if you intend to hold a bond to maturity, you typically can ignore its fluctuating price and yield, assuming that the issuer is still able to pay you as scheduled.
Q:You sometimes hear that rising bond prices are a good thing and that rising bond yields are also a good thing. How can both be true when they move in opposite directions?
A:Rising bond prices are good news for a person who owns a bond. They mean that investors are willing to pay more for the bond. Rising yields are good news for a person who wants to buy a bond. Remember that rising yields typically mean that bond prices are dropping. The buyer can get the same interest payments for less money.
Q:You own a corporate bond and the issuing company reports a large operating loss for its fiscal quarter. What concern should you have related to the bond’s rating?
A:This could indicate further financial problems with the issuer. Negative news would impact price adversely and if you intend to sell the bond, you may not be able to command as high a price as you paid for it. Credit Rating Agencies such as Standard & Poor’s may also downgrade the bond’s rating.
Fixed income eBook
Read our short guide, which explains how fixed income securities (or bonds as they are also known) work and how they can fit into your portfolio.
Read the eBook
The information contained in this material is general information only and does not take into account your objectives, financial situation or needs. Before acting on the information contained in this material you should consider the appropriateness of the information in regard to your objective, financial situation and needs before making any decision about whether to invest, or to continue to hold an investment.
The repayment of capital and performance of an investment is not guaranteed by Schroders or any other party. Opinions constitute our judgement at the time of issue and are subject to change. Past performance is not an indicator of future performance. Investment guidelines represented are internal only and are subject to change without notice. Schroders may record and monitor telephone calls for security, training and compliance purposes.
