In Part I of our bond series, Azzet explained what bonds are, the types of interest they pay, and what happens when you sell. In Part II, we delve into how bonds actually work.
Missed Part I? Bonds... The fine art of investing in bonds - Part I
How bonds work: The machinations
All bonds have a set value (called the face value) when they’re first issued, typically at a nominal value of $100 and assuming you hold a bond until maturity, this is the amount you’ll get back.
However, the current yield is the annual interest payment calculated as a percentage of the bond’s market price.
AAA-rated government bonds do provide an enviable level of credit quality but there’s no certainty that during bull markets they will trade at premiums to their $100 face value.
For example, if the central bank lowers interest rates from 3% to 2% the bond you bought with a coupon rate of 3% would now be worth more in price than a new bond issued with a 2% coupon rate.
Here’s a useful insight into how bonds actually work
An attractive annual coupon might be expected to offer, for argument’s sake 5.25% to 6.25%. But it’s also important to remember that it's not uncommon for capital values to exceed $110.
Hence, the further out that (fixed income) instrument is dated, the higher the capital value is likely to be.
Once you see what can happen if bonds are held to maturity, you’ll start to understand why portfolios that hold bonds need to be actively managed, to ensure you’re not left out of the money.
For example, if in the lead-up to maturity, yields move higher as a bull market in government bonds comes to an end - and your portfolio isn’t actively managed - a move higher in yields will result in lower capital values and potentially negative returns as the value of coupons is offset by higher capital losses.
The combined impact of solid annual returns, plus capital losses at maturity (once you realise the bond’s $100 face value), is a “real” yield of between 2.5% and 3.5%.
Classic example
Here’s another way to look at it If all this sounds a little hazy, here’s a classic example to help clarify.
A Treasury bond is due to mature in five years, offering an attractive annual coupon of 5.5% based on a purchase price of $100. The market has rallied and the bond is now trading at $114. Purchasing the bond at $114 results in a yield to maturity of 2.8%.
If you’re considering adding bonds to your portfolio, use this calculation to figure out how much you will earn (the bond’s yield if held until maturity).
Current Yield = (Annual Dollar Interest Paid / Market Price) x 100%.
A bond with a $100 par value, trading at the discounted price of $95.92 and paying a coupon rate of 5%, would have a current yield of 5.21%. (0.05 x $100) / $95.92) x 100% = 5.21%.
An ASX example
Another way to explain this is via a share market example, as most investors draw their personal experiences and insights from the ASX.
The current board at company ABC (fictitious) has indicated shareholders can expect an annual payout, in two tranches of 16c. With ABC shares trading at $3.33, this implies the yield on offer is 4.8%.
However, it wasn’t that long ago when those shares (in ABC) were trading at $2.70. At that price, the yield on the same payout of 16c would have been 5.92%.
If we are to assume ABC shares might be on their way to $3.50, or maybe even $4.00, and dividends remain at 16c, then the yield on offer at those prices will be 4.57% and 4% respectively.
This is the same principle that applies to bonds.
Technical terms you must understand
While there are a number of key terms you really need to grasp before you buy bonds, the techno-jargon the industry loves to use can make it appear a lot more complex than it is.
With that in mind, we’ve stripped down these terms and put them in plain English.
• Maturity date: Is the time frame within which the bond is due to be repaid. The longer the maturity, the higher the yield tends to be, with investors wanting to be rewarded with a higher rate of lending in the long-term.
• Rate or running yield: Is the market interest rate of a particular bond for a particular maturity. For example, the Australian 10-year bond rate was (at the time of writing) around 1.81%, and the three-year bond rate was 0.096%.
• Bond price: Goes down as yield goes up. The further out the maturity date, the more exposed the bond price is to movements in yields.
• The spread: Is the difference in rates between one bond and another. For example, the difference between the US and Australian 10-year rate; or the difference between the two-year rate and the 10-year rate. The credit spread refers to the difference between the government bond rate and a particular state or corporate bond and as such also measures additional risk.
• Yield curve: Charts out the rates for different maturities. Steep yield curves typically denote a sizable gulf between high long-term rates and relatively low short-term rates.
• Face value: Reflects the ascribed value of the bond, typically $100 for government bonds, $10,000 for corporate bonds. This also reflects the principal amount lent to the bond issuer which they will repay you when the bond matures.
• Coupon rate: This is the interest rate paid to you, the bondholder, either quarterly, semi-annually or annually. Making sense of the current bond market As you may have noticed, there has recently been a lot of media hype around the rise in bond rates, and the speed at which they’ve gone up. While it may appear complicated, what’s been driving rising bond rates is market optimism about the economic recovery, with the bounce-back from the pandemic now expected to be a lot quicker than previously thought.
