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Everything you need to know about bonds
Bond yields have become one of the biggest and most important talking points within investment markets in 2022. At their most simple, bonds and the interest or yields they offer, represents the so-called risk-free rate off which every other asset class in the world is priced.
The purpose of this article isn’t to discuss the outlook, risks, opportunities, or the like, but provide a ‘bonds for dummies’ introduction and demystify the jargon around this important portion of portfolios.
Bonds are among the oldest investments in the world, they represent a loan made to another person, entity or government. The simplest for of bond is a term deposit, which effectively involves the owner, lending money to a bank in return for an interest payment.
Par Value – The par value of a bond is simply the amount lent to the borrower and the amount that must be repaid. In general, bonds do not allow interest to be ‘capitalised’ or reinvested.
Coupons – This interest payment is known as a coupon, that being the amount paid to the lender in return for providing the capital. As the risk of default increases, so should the coupon. This is typically represented by an interest rate, say 1 per cent, which is multiplied by the amount borrowed, and paid at regular interviews throughout the term.
Fixed and variable rates – The payment of the coupon can be based on either a fixed or variable interest rate, not unlike a mortgage. For a fixed rate this means the same payment will be made through the term of a bond, with a government bond the most common. Variable rates are more popular in the corporate and private markets, where each quarterly or monthly interest payment is recalculated based on a ‘market’ rate of interest, with the Bank Bill or Aggregate Bond Index an example. The payments can both increase and reduce as a result.
Basis point – Another one of those complex financial concepts used to confuse investors. A basis point is simple a measure of percentage with 1 basis point equating to 0.01 per cent. Or 1000 basis points being 10 per cent.
Yield – The yield on a bond is an estimate of the income return that the investor will receive if they were to purchase that bond today. It is calculated by dividing the most recent interest payment by the par value to determine what the average interest rate would be today. This is relevant because bonds trade in a similar way as shares, on a daily basis, and therefore their values and potential returns will fluctuate.
Yield to Maturity – Or YTM is an extension of the yield calculation but is forward looking. That is, if you are purchasing a 10-year bond, 2 years into its term, the YTM represents the total annualised interest you will receive over this period.
Term to Maturity – The term to maturity is the amount of time, in years, until any bond or loan must be repaid at the first instance. For a home mortgage, this is usually 30 years.
Duration – Among the more challenging concepts to understand is the ‘duration’ risk within a bond portfolio. Duration is a measure of a portfolio of bonds sensitivity to moves in interest rates. That is, for a bond portfolio with a duration of 8, which is similar to the bond ‘index’ an investor can expect to lose (or gain) 8 per cent of the value of their capital if bond yields or interest rates were to increase by 1 per cent.
Secured / Unsecured – This is among the more granular concepts regarding bonds, which relates to the type of assets that are securing the mortgage. That is, if the borrower doesn’t pay their interest, what can the borrower take in order to be repaid. In many cases, this is property.
