This is the first in a series of briefings designed to demystify the world of bonds. Here we will take a snapshot look at the basic principles of bonds , who issues them and why, as well as some of the key points needed to understand the principles on which bonds work. It should be noted that the world of bonds is huge, with a vast array of classes, categories, risk levels and potential returns. That variety will be addressed in subsequent briefings but, for now, we’re going to keep things simple.
Bonds constitute a form of borrowing. One party borrows money from another with the agreement to repay the money along with interest, over a given period of time such as 10 years. That agreement is the “bond”, from which this form of debt gets its name.
The term “bond” can be used to cover a variety of saving, investment and borrowing opportunities, so it is useful at this point to clarify what we are talking about.
For the purpose of this document, we are discussing the sort of bonds that ordinary private individuals usually cannot buy, and that tend to form part of a diversified investment portfolio.
These bonds do not include forms of retail saving that might use the term “bond” such as Premium Bonds or fixed-term bonds that are offered to private individuals by retail banks.
Rather, these are bonds that are “issued” (sold to investors) by governments or large companies. The issuer tends to issue several million pounds-worth of bonds at a time, with the aim of persuading large investment and insurance companies to buy them. The more investors the issuer can persuade to buy the bonds, the lower the interest payment the issuer is likely to have to pay i.e. the cheaper it is for the issuer to borrow money from the investors.
Governments and large companies issue bonds.
Governments issue bonds for a number of reasons. Firstly, they might need to pay for large public investments such as roads, hospitals or other infrastructure. Secondly, they might not be raising sufficient funds through taxes to meet their ongoing obligations, including paying the salaries of public servants or sustaining the welfare state. These government bonds make up the majority of what people talk about when they refer to public debt.
Companies borrow for similar reasons. If a company wants to build a new factory but has insufficient cash to hand, banks might not be willing to take on the risk of lending a large sum of money to a single company.
However, by selling bonds to lots of different investors, the risk of lending is spread across lots of different people, leaving each individual investor taking on a small proportion of the risk.
As with most forms of borrowing, bonds tend to have a fixed lifespan. Lenders want to know when they can expect to get their money back, otherwise they’re less likely to lend i.e. less likely to buy the bond in question.
Bonds can have a lifespan as short as three months or as long as 30 years, or even longer. A small number of bonds don’t have a maturity date, i.e. a date on which the issuer returns the investor’s money along with any outstanding interest payments.
Such perpetual bonds, or “perps”, do not repay the investor’s capital, so the issuer has to be of extremely sound financial standing if an investor is to risk lending to them. Even then, a further incentive is also often needed which is why perpetual bonds still in existence include war bonds issued by the British Treasury to help fund the country’s effort during the first world war. In that instance, the extra incentive was the emotional pull of patriotism.
This hints at a basic principle that underpins bonds. The greater the risk, the greater the potential return that investors require. In this example, the risk for the investor is that of losing access to the money for a long period of time, as well as the rising risk that the bond issuer might fail to maintain payments.
The initial reason for this is obvious: the inconvenience of not being able to use that money for something else grows with every passing day.
When first encountered, bonds and what they pay can seem confusing and counter-intuitive. Fear not. It’s actually relatively straight-forward providing you remember this key point:
Let’s look at the significance of this:
1. A bond is often thought of as paying the investor £100 when the lifespan of the bond ends. In technical terms, bonds are assumed to have a face value of £100 on maturity.
2. Most bonds make a fixed (usually annual) payment or “coupon”.
3. Let’s assume that the issuer pays a £5 annual coupon.
4. This annual coupon will remain at £5 for the entire lifespan of the bond.
5. The bond might be issued at a price of £90 (the issue price is usually less than the face value to provide an incentive to the investor)
6. If the coupon is £5 a year, then the yield is £5 (coupon) ÷ £90 (price) = 5.56% (yield)
7. If demand for that bond goes up, then that would push the price up.
8. The annual coupon is unaffected by price changes. It remains £5.
9. If the price rises to £110, then the yield becomes £5 ÷ £110↑ = ↓4.55%
10. This shows that if the bond’s price rises↑, its ↓yield falls and vice versa.
Key point: When the bond price goes up, its yield goes down (and vice versa)
There is some logic in this. For example, if a large number of investors try to sell the same bond at the same time, this will force the price of that bond down. This is because the sellers are competing with each other to get someone to buy. And, as we have seen, if the price falls, the yield goes up. At some point, the yield (the return for holding the bond) will be high enough to persuade a new investor that the bond is worth buying.
This begs the question, “what causes the demand for and price of a bond to fall or rise?”
Let’s take inflation first. Inflation is the rate at which prices are rising. So if a basket of goods cost £100.00 a year ago, but costs £103.25 today, then year-on-year inflation can be said to be 3.25%. We can apply the same principle to the future. If inflation is expected to remain at 3.25%, then £100 in a year’s time will buy around 3% less than it does today. In other words, the value of £100 will fall.
That’s important for bonds because they usually pay a fixed annual coupon. The higher the rate of inflation, the less that fixed annual coupon is worth as each year passes. That’s why investors might prefer other investments that could have a better chance of keeping up with or beating inflation. The point being that, if investors expect inflation to rise, bonds become less attractive as an investment. That pushes demand for bonds down, and that drags bond prices down as well.
Rising interest rates have a similar effect. A savings account with variable interest can be considered to be a relatively low-risk investment. Such a savings account can increase the interest paid on savings as underlying interest rates are increased. When interest paid on a savings account increases, its attractiveness might increase in comparison to a bond that pays a fixed coupon.
Those underlying interest rates might be increased by a central bank (such as the Bank of England) in order to keep inflation under control. That’s why, when economic data are released indicating a potential rise in inflation, the demand for and price of bonds often fall.
Unsurprisingly, there are some institutions that issue inflation-linked bonds or “linkers”. As the title suggests, these are bonds on which the coupon can increase or decrease in parallel with inflation.
As a result, inflation-linked bonds move the risks associated with inflation from the investor to the issuer. In other words, if inflation rises faster than the issuer expected, they will have to increase the annual coupon payments more than they had anticipated.
That’s why there are far fewer issuers of inflation-linked bonds. One of the biggest is the UK government. It began issuing them in 1981 and these have become extremely popular with insurance and pension providers. This is because it gives them a predictable income stream to offset against insurance and pension pay-outs that they’ll have to make in future.
Because the risk of buying inflation-linked bonds tends to be lower, the yield that they pay investors is also lower.
Drawing the key points together, we can see that bonds are a form of large-scale borrowing in which a large pool of investors can lend to a company or government in return for annual payments. They might also be able to buy the bond at a lower price than its face value.
As well as providing issuers with financing, they also provide investors with what can be a fairly stable income stream or total return.
The demand for and prices of bonds can reveal a number of things about the issuers and their countries, but these will be covered in subsequent articles. In the meantime, if you have any further questions, please do not hesitate to contact your Private Banking and Advice Manager.
Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at February 2019.
Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
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