What are bonds

With no return on deposits at present, people are looking to see if there are other assets they can invest in and get a return. Bonds are traditionally a safe investment but they can fall in value as well as rise. There are in fact, more bonds traded on a daily basis than shares and they can be very complex.

What are bonds?

Bonds are loans given to a government, state or corporation. Instead of going to a bank like you or I would, they look for these loans on the stock market. A bond is like an interest only loan in that the borrower pays a regular interest payment (called a coupon) for the term of the bond. At the end of the term, they repay the amount they borrowed.

Bonds are traded daily on the stock exchange and their price can fluctuate based on market conditions. Just because a bond is issued at €100, doesn’t mean you will buy it for that price if you buy a bond during it’s term. You can but it for more or less than the original price.

What effects the price of a bond

There are two main drivers that effect the return that you get from a bond:

Term Premium – How long is the term of the bond. If the borrower is looking for a short term loan, the interest rate is lower than if the repayment is over decades. If you are giving someone money for 10 years, a lot of things can happen. Take at present, interest rates are very low. If they go up, the coupon I get on my bond doesn’t look as attractive. But who is going to buy my bond with the fixed interest rate when they can get just as good a rate just leaving their money on deposit?

Credit Premium – What are the chances of getting my money back? If you invest in solid companies or large economies, your money is very secure. The German Bund is seen as the safest place for your money in the EU. As such, the coupon paid is very low.

Then take a country like Greece, who desperately need money but you know there is a good chance you won’t get your money back. If you are going to give them a loan, you are going to charge a higher interest rate to compensate you for the risk of them defaulting. These high risk bonds are called “junk bonds”.

The credit crunch recession was caused by large, institutional banks (low risk) packaging multiple home loans from poor people (high risk) and then getting the rating agencies to give them a low risk rating. When the poor people started to default on their loans, it all came tumbling down.

What return can you get?

We know the coupon payable, the maturity date and the amount paid back (the amount that was borrowed), so we can calculate how much money we will make at the end of the term. It’s pretty easy if we buy the bond when it is issued and hold it to maturity e.g. 4.5% 10 year bond, will pay €4.50 a year for 10 years, so €45 for every €100 bond.

But bonds are traded every day and the price of the bond changes constantly. If you buy the bond at below the redemption price, you can make a profit when the bond term ends. But there may also be situations where you buy a bond at above the redemption price which means you will get less than you paid for it. You will have to assess whether the coupon you will receive during the term will make up for the loss you will make in the future.

The effect of interest on bond prices

Something that people always forget when making a long term investment is the effect of inflation on the value of our money. If I invest €100 in a 10 year bond, the €100 I get back in 10 years time won’t buy me the same amount as it does today. And the same goes with the coupon I receive. The €4.50 I receive next year will be worth more than the €4.50 I receive in 10 years time.

When investing in bonds, we are taking an element of investment risk with our money. So we want to make sure the return we get is higher than the no risk interest rate on offer from the ECB. What if I buy a 10 year bond today with a coupon rate of 4.5%. I am getting a higher return than deposits. But then the ECB increases rates, so my bond becomes less attractive as the difference in the risk free rate and my bond rate is smaller. I have a 10 year bond, so there are 10 coupon payments at this less attractive rate, so the value of this bond will go down more than one with say 3 years coupons to be paid.

There is a calculation called the Gross Redemption Yield which takes relationship between the coupon rate, interest rate and remaining term into consideration to determine the price. It’s a bit complicated to go into here but it can be calculated using a financial calculator.

I hope this gives you some understanding of bonds. They have always been marketed as a safe strategy for investors. While they are not as volatile as equities, they do fall in value and can offer little or no return for periods of time.

If you have any questions, send me an email at steven@bluewaterfp.ie