Bonds; How do they work, when do they increase in value and how do they fit into your portfolio?

Today’s episode stems from the question last week from William about investment bonds (an investment vehicle, kinda like a life insurance product). Today however, we’re talking about the asset class of Bonds

What are bonds?

1. A bond is a debt instrument – a form of lending.
   • Part of the ‘Fixed Interest’ asset class (ever seen a multi sector asset allocation, like inside a Super Fund)
2. Financial Product designed to raise money for the entity that issues the bond
   • I liken it to an interest only loan – If you need money, you borrow it (like a mortgage) which you pay back along with interest too.
   • When a company or the Government needs money, someone (you) purchase that bond – Essentially loaning money to the issuer who then pays you interest (coupons)
     • At the Bond Maturity – you get the initial loan back (unlike a PI loan)

Basic Terms

1. Face value: This is the nominal value of the bond, typically $100. It also refers to the principal lent to the bond issuer which they commit to repay to investors when the bond matures.
   • NOTE: This is not the price – but we’ll come back to this a bit later
2. Coupon rate: The annual interest paid to the investor and is calculated as a percentage of the face value.
   • 5% Rate = $5 p.a. on a $100 FV bond, or $50 on a $1,000 FV bond
   • 6% rate = $2.6 on a $100FV
3. Maturity date: This is the date the bonds effectively expires and final payments are made to investors. These payments include the initial loan and the final coupon

Types of Bonds

– Who needs to raise money?

1. Government
   • 1988 to 2008: $50-100bn on issue
   • Since 2008 has risen – $500bn
2. Corporate – Since 2000 gone crazy – $200bn to $1.1 trillion
3. Total Market Size = $1.8 trillion – About the size of the ASX300 on any given day

Designed to be a defensive asset

Due to the fixed rate nature of a bond and lower level of risk they carry in general, bonds are considered a defensive asset.

1. They are debt – but creditors are paid back before equity holders
   • If a company defaults they will pay back the debt holders first before share holders
2. The Risks – risk does lie is in the chance of the bond issuer defaulting on the loan
   • The levels of risk vary – e.g. The Australian Government is safer than a small mining company
   • Typically, government is considered safe compared to corporate
     • Unless government is Greece and are at risk of defaulting on debt

Where the bond is being bought is also a factor.

That is, the Primary or Secondary market

1. Primary – Buying bond directly from issuer – When a bond is first issued you can purchase it directly from the company
   • Price here will be the Face Value e.g. $100 FV = $100 price
2. Secondary – afterwards, they are listed on the secondary market where investors can buy and sell their bonds.
3. Price – Remember the Face Value, it is not the price once it has been listed on the secondary market
   • Face value of a bond remains fixed for its lifetime
   • Price/value of the bond fluctuates due to changes in market conditions, particularly changes in interest rates

Mechanics

1. Interest rates – Given that bonds are debt, they are related in pricing to interest rates
   • Interest rates rise – Bond price goes down
   • Interest rates fall – Bond price goes up
   • Negative correlation with Interest rates
2. Example:
   • FV of $100 on a bond
   • Bond has a coupon rate of 5% and the interest rate in the economy is 5%
   • The Price = Face Value at $100 – That is due to interest and coupon being the same
   • Falling interest – Interest rates go to 3% – Bond price might go to $108 from $100
     • Bond is more attractive now – Better coupon than cash – the value of it is better now
   • Rising interest – Interest rates go to 7% – Bond price might be $92 from $100
     • The bond will be less attractive as it is slightly riskier than cash, so the price will go down as why by a bond when you can get 2% extra in cash?

How much will the price change when interest rates change?

This is based on Duration:

1. How sensitive a bond will be to interest rate changes? Measured by technical term called duration – slightly confusing as it is based around time to maturity, but isn’t the only factor:
   • The duration is based on the time until maturity – Longer duration more sensitive to changes in price
2. Rough rule of thumb – Per number in the duration = 1% interest change = 1% price change
   • Duration of 5 = 5% price change for every 1% interest rate change
   • Duration of 20 = 20% change in price
3. When is higher duration better?
   • When interest rates are expected to drop – As the rise in bond prices will be greater
   • Long duration bonds are typically shunned if rates are going to rise

Where Bonds Fit in?

1. Typically form a defensive component of a portfolio
   • Depending on tolerance to risk (Volatility) – They can be good
2. Uncorrelated asset – Performs in opposite direction to shares/property
   • Shares Crash (2008) then bonds typically rise

The negative aspects of bonds

1. No growth to offset inflation
   • Can get inflation linked bonds – But they still may fail outpace the traditional growth investments over the long term
2. AUD gov bonds pay about a 2.6% yield – almost the same as term deposit rates
3. 30-year bond – Face value of $100 in 30 years is worth about $48 with inflation of 2.5%.

Summary

1. Bonds are a debt instrument (Fixed Interest)
2. Defensive – or as defensive as who issues them
3. Buy someone’s debt and get interest (called coupon payments) for loaning them money
4. They have their time and place – Stable income returners, provide capital protection