Explore the fundamentals of investing in bonds, which are known for their relatively lower risk compared to other financial instruments and are often an important component of diversified investment portfolios.
A bond is a financial security that entitles its holder to regular income payments, typically in the form of interest, from the entity that issues the bond (the issuer). The issuer, upon selling a bond, becomes indebted to the bondholder and is obligated to pay back the principal amount at maturity and make scheduled interest payments.
As debt instruments, bonds are distinct from equities like stocks; bondholders are creditors to the issuer and generally do not have ownership rights or claims to dividends or co-ownership.
The role of bonds in building a diversified portfolio
The first principle is usually simple: the lower priced risk of bankruptcy, the higher bond price (and lower yield). The higher risk of bankruptcy, the lower bond price (and higher yield). Bonds are fixed income securities, separate from stocks, where investors don’t know their future yields. There are a lot of types of bonds such as government bonds as US treasuries or high-yield bonds of distressed companies.
Bonds are typically characterized by their relative stability compared to assets like stocks, often exhibiting less price volatility. This stability allows investors to diversify their portfolios by including a mix of asset classes with varying risk levels. Incorporating bonds alongside stocks or other assets can balance the overall composition of a portfolio, working together to reduce the risk of capital loss and lower volatility across the portfolio. However, it’s crucial to recognize that bonds still carry some risk, and their impact on portfolio stability can vary depending on the type of bond and market conditions. When constructing a diversified portfolio, understanding the different types of bonds and their unique characteristics is essential.
Types of bonds
Bonds can be categorized in numerous ways, one of which is by their issuers. Within this classification, we can identify three primary types of bonds:
- Government Bonds: Issued by national governments, typically through their treasury departments, these bonds are sold domestically and internationally to finance government expenditures, often including the state budget deficit. While they are considered relatively safe investments, especially in stable countries, their popularity can vary based on economic conditions and investor preferences.
- Corporate Bonds: These bonds are issued by companies to raise capital for various purposes, such as business expansion, project financing, or debt refinancing. Compared to government bonds, corporate bonds generally carry higher risk, reflecting the greater uncertainty in corporate earnings and financial stability.
- Municipal Bonds: Issued by local government entities, such as cities and municipalities, municipal bonds can be used to finance public projects, infrastructure, or manage local debt. While they often offer stable investment returns and are backed by the issuing municipality’s resources, the risk and attractiveness can vary. Investors need to consider the financial health and creditworthiness of the issuing municipality, as these factors can impact the bond’s safety and return.
Pricing
- Face Value: This is the amount that the bond issuer agrees to pay back to the bondholder at maturity, essentially representing the debt owed to bondholders.
- Issuance Price: This is the price at which a bond is initially sold to investors when it is first issued. The issuance price is set by the issuer and can be at par, above (premium), or below (discount) the face value, depending on market conditions and other factors.
- Transaction Price: This is the price at which a bond is traded in the market during its life. The transaction price can vary above or below the issuance price based on changes in interest rates, the issuer’s creditworthiness, and other market factors.
Bond yields
Bond yields represent the return an investor can expect from investing in a bond, influenced by factors such as the bond’s interest rate (coupon rate), maturity date, and market price. These yields fluctuate over time, significantly affected by prevailing market interest rates. When market interest rates rise, the price of existing bonds typically falls, leading to higher yields on these bonds to make them more attractive relative to new bonds issued at the higher rates. Conversely, when market interest rates fall, prices of existing bonds rise, which lowers their yields, aligning them with the yields of new bonds issued at these lower rates.
Maturity
Bond maturity refers to the length of time until the principal amount of a bond is due to be repaid by the issuer, calculated from the date of issuance to the repayment date. At maturity, the bondholder usually receives an amount equal to the face value of the bond, along with any final interest payment due. Since interest payments and the maturity date are predetermined, they offer a stable and predictable source of income. Bonds can be categorized as short-term (with a maturity of less than 1 year), medium-term (maturity between 1 and 5 years), and long-term (maturity of more than 5 years). It’s important to note that treasury bonds, like other bonds, can be sold in the market before their maturity date, but the sale price may result in a capital gain or loss depending on market conditions, rather than a reduction in the interest amount.
Associated risks
Although bonds are generally considered a safer asset class compared to, for example, stocks, it’s important to recognize that they are not devoid of investment risks. Investors considering bond investments should be aware of the various risks involved. The main categories include:
- Interest rate risk: Fixed-rate bonds are more susceptible to losing market value when interest rates rise. This is because their fixed interest payments become less attractive compared to new bonds issued at higher rates, not because the interest rate of the bond itself increases. This can affect investors who intend to sell their bonds before maturity. Additionally, bonds with longer maturities experience greater price volatility in response to interest rate changes. Therefore, in anticipation of rising rates, investors might shift their portfolios towards shorter-maturity bonds to reduce exposure to this volatility. Conversely, if a drop in rates is expected, they might favor longer-term securities to capitalize on potential price increases.
- Credit risk: Investing in debt instruments carries the risk that the issuer may encounter financial difficulties. This can lead to delays in interest payments or, in extreme cases, default and bankruptcy. However, it should be emphasized that such extreme situations are not commonplace.
- Inflation risk: It is closely linked to interest rate risk. When inflation is expected to rise, interest rates often increase as a response. This increase in interest rates typically leads to a decrease in bond prices. The reason behind this is that as inflation erodes the value of money over time, investors demand higher returns to compensate for the reduced purchasing power of future cash flows.
- Liquidity risk: This type of risk occurs when a bond cannot be bought or sold quickly without causing a significant impact on its price. This means that in situations with low liquidity, selling the asset might necessitate a price reduction, while purchasing might require a higher price. Another aspect of liquidity risk is the challenge in accurately valuing illiquid financial instruments within a portfolio, as their market price is not easily determined. In extreme cases, liquidity risk can lead to a scenario where it is virtually impossible to buy or sell the bonds at all.
Bonds rating
A bond rating is an assessment of an issuer’s creditworthiness, measuring the risk associated with investing in their debt instruments. Rating agencies assign these ratings based on an analysis of various factors, including economic, political, and social risks. The rating can be either long-term or short-term. Some of the most influential rating agencies include:
Fitch Ratings
Located in the USA, Fitch Ratings publishes ratings for financial institutions, enterprises, and countries. They use various scales, with the credit rating scale ranging from ‘AAA’ (highest credit quality, lowest risk) to ‘D’ (default, highest risk).
Moody’s
An American company and a pioneer in analyzing the creditworthiness of treasury bonds. Its subsidiary, Moody’s Investors Service, specializes in bond ratings, using a scale from ‘Aaa’ (highest quality) to ‘C’ (lowest quality, often in default). They evaluate debt instruments across several market segments, including government, municipal, and corporate bonds.
Standard & Poor’s (S&P)
An American agency known for its analyses and reports on joint-stock companies and their issued bonds. S&P rates on a scale from ‘AAA’ (highest quality) to ‘D’ (default), providing opinions on the level of credit risk for various economic entities, including joint-stock companies, cities, and countries.
Bonds and interest rates
As already mentioned, there is a very close, inverse relationship between bonds and interest rates. Understanding this relationship can offer investment opportunities, despite the inherent risks. Specifically, as interest rates rise, the price of existing bonds tends to fall, and conversely, as interest rates fall, the market price of these bonds tends to rise due to the increased attractiveness of their fixed future income relative to newer bonds at lower rates.
For bondholders, the most important parameter is the Yield to Maturity (YTM), which determines the total expected return, considering the purchase price, coupon rate, and time to maturity. The maturity length of a bond significantly influences its sensitivity to interest rate changes; longer-term bonds are more affected by rate fluctuations than short-term bonds. While these longer-term bonds may offer higher yields to compensate for increased interest rate risk, this does not guarantee higher profitability. Investors anticipating a fall in interest rates might favor longer-dated bonds, which could potentially provide higher yields compared to shorter-dated bonds in such scenarios.
Bond laddering
As mentioned above, the characteristic feature of bonds is their maturity date. The shorter this date is, the less ongoing income a bondholder may receive, which can affect their sense of financial liquidity over time. To counter this, a popular strategy is the creation of a so-called financial ladder. This involves building an investment portfolio that includes bonds with a variety of maturity dates. With this approach, even as income from a short-term bond comes to an end, the investor continues to receive income from bonds with longer maturities. This staggered structure ensures a more consistent and prolonged income stream, compensating for the shorter income period of individual bonds.
Bonds in times of economic downturn
While investing in stocks during an economic crisis can be challenging due to higher volatility, the situation can be different for bonds. Bonds, particularly treasury bonds, may help stabilize a portfolio or limit losses during economic slowdowns. This is because treasury bonds are backed by the government, offering a higher level of security due to the government’s responsibility to redeem them and pay interest. However, it’s important to note that this principle is not infallible in the face of unpredictable, extreme events such as pandemics or wars, which can disrupt even the most stable investments. While such events are rare, their economic consequences can be significant and should be considered in any investment strategy.
Duration and convexity
Duration is a measure of risk that indicates the approximate percentage increase or decrease in a bond’s value when the yield rate changes by 1 percentage point. This risk increases the more sensitive the instrument is to changes in the income rate (the longer the maturity period and the lower the interest rate, the greater the sensitivity). This is because over a longer period of time, the chance of rate changes increases.
Convexity, on the other hand, measures the curvature in the relationship between a bond’s price and its yield. Simply put, it indicates how the duration of this instrument will change when interest rates change. Its task is to correct the discrepancy between interest rates and bond prices. It does this by taking into account the impact that interest rates may have on duration.
We can distinguish two types of convexity:
- Positive convexity occurs when the bond’s duration increases as its price rises (usually when yields fall), which can be beneficial for bondholders as it indicates greater price increases for yield decreases.
- Negative convexity, often seen in callable bonds, occurs when the duration decreases as the bond price increases, which can be less favorable for investors as it limits price appreciation in a falling yield environment.
Thanks to their generally lower level of risk compared to stocks, bonds can be an attractive investment instrument for many investors. However, it’s crucial to understand how various market factors can influence a bond’s value, price, and the fixed interest payments received by the bondholder. Investing in bonds can be an effective strategy to diversify an investment portfolio and mitigate potential losses from its more volatile components. Before investing, it is important to research the bond’s rating from a credit rating agency and understand the economic situation of the issuer to better assess the associated risks.