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

Finance & Fury Podcast

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